Indonesia Selected Issues - IMF Country Report 07

© 2007 International Monetary Fund August 2007
IMF Country Report No. 07/273
Indonesia: Selected Issues
This Selected Issues paper for Indonesia was prepared by a staff team of the International Monetary
Fund as background documentation for the periodic consultation with the member country. It is based
on the information available at the time it was completed on June 27, 2007. The views expressed in
this document are those of the staff team and do not necessarily reflect the views of the government
of Indonesia or the Executive Board of the IMF.
The policy of publication of staff reports and other documents by the IMF allows for the deletion of
market-sensitive information.
To assist the IMF in evaluating the publication policy, reader comments are invited and may be
sent by e-mail to publicationpolicy@imf.org.
Copies of this report are available to the public from
International Monetary Fund ● Publication Services

700 19th Street, N.W. ● Washington, D.C. 20431
Telephone: (202) 623 7430 ● Telefax: (202) 623 7201
E-mail: publications@imf.org ● Internet: http://www.imf.org
Price: $18.00 a copy
International Monetary Fund

Washington, D.C.
INTERNATIONAL MONETARY FUND
INDONESIA
Selected Issues
Prepared by Nita Thacker, Christopher Crowe, R. Armando Morales (both APD),

Sonali Jain Chandra (PDR), Amine Mati (FAD), and
Steven Seelig (MCM)
Approved by the Asia and Pacific Department
June 27, 2007
Contents Page
I. Introduction....................................................................................................................2
II. Is Indonesia Adequately Integrated into Global and Regional Trade and Finance?......4
III. Indonesia, 1997 vs. 2007: How Far Has Crisis Vulnerability Been Reduced? ...........17
IV. Building a Financial Safety Net in Indonesia ..............................................................35
V. Post Crisis Credit Expansion in Indonesia...................................................................50
VI. Creating Fiscal Space...................................................................................................72

2
I. INTRODUCTION
1. The chapters in this volume present some of the background work for the 2007
Article IV consultation. They were prepared to help address key policy questions raised
during the discussions. Staff findings on these issues formed the basis of the policy
recommendations provided to the authorities, as highlighted in the staff report for the
2007 Article IV consultation.
2. While the recent boom in commodity exports has benefited Indonesia, export
performance in many other sectors has lagged behind other countries in the region. This
includes the labor-intensive manufacturing sector which is of key importance for
employment creation. Using a gravity model, Chapter II assesses Indonesia’s trade
integration relative to underlying country characteristics and confirms that Indonesia trades
less than could be expected based on fundamentals. One reason has been Indonesia’s lack of
integration in the dynamic regional supply chains that have generated positive spillover
effects for other Asian countries. This, in turn, reflects weak FDI inflows as Indonesia lags
behind its neighbors on most investment climate indicators.
3. Although FDI inflows have remained small, portfolio inflows have surged
periodically driven by improved macroeconomic fundamentals, a still significant yield
differential, and high global risk appetite. The authorities expressed concern that sudden
reversals could undermine macroeconomic stability and derail the progress made since the
crisis. Chapter III analyzes Indonesia’s vulnerabilities, especially compared with the eve of
the crisis in 1997. Various indicators suggest that the underlying fundamentals are
significantly stronger and the institutional structure, most notably in the financial and
corporate sectors, is more robust. Combined with the adequate reserve ratios and a flexible
exchange rate system, they make the economy much more resilient to volatile capital flows.
The challenge now is to consolidate the progress that has been achieved and adapt policies to
the changing external environment.
4. The absence of a financial safety net (FSN) prior to the 1997–98 financial crisis
contributed to vulnerabilities and the severity of the crisis. Much progress has been
achieved since and the introduction of a FSN in Indonesia was completed in March 2007.
This element of Indonesia’s financial infrastructure will continue to gain importance as the
authorities are committed to promoting financial intermediation and the role of the financial
sector in the economy. Chapter IV analyzes the key features of the FSN in view of
international standards and concludes that the current system is capable of timely addressing
bank problems. However, the system could be strengthened further and staff laid out some
proposals that could be implemented in the future.
5. Improving financial intermediation has been a priority of the authorities. In

particular, they have expressed concern that the banking system is not adequately performing
3
its financial intermediation role and contributing to economic growth. Chapter V looks at
determinants of, and constraints to, credit growth in recent years. Staff found that while the
expansion of short-term lending is likely to be constrained by limited demand from credit-
worthy customers, the limited availability of long-term credit is the result of various
structural weaknesses, including the absence of a well-developed nonbank financial market.
Staff suggested that rather than relaxing prudential regulations or using moral suasion to
encourage banks to lend, authorities should focus on promoting the availability of long-term
lending instruments and development of capital markets.
6. Indonesia needs to create fiscal space to help meet its large infrastructure and
poverty reduction goals. The last chapter looks at the scope for creating fiscal space, both
through improving revenue collections and through reprioritizing spending, to help
accommodate priority spending. Staff finds that, in addition to ongoing efforts to improve tax
administration, new tax policy initiatives could be considered. On the spending side, further
continued gains in spending efficiency and a reduction in subsidies could create much needed
fiscal space. In addition, improved budget allocation and better public financial management
systems could improve regional governments’ ability to use accumulated deposits for key
priority spending.
4
II. IS INDONESIA ADEQUATELY INTEGRATED INTO GLOBAL AND REGIONAL TRADE AND
FINANCE?1
A. Introduction
7. This paper examines the integration of Indonesia into the regional and global
economy. While Indonesia fares better on various indicators of trade restrictiveness than the
regional average, it fares worse in terms of actual openness, with trade-to-GDP ratios well
below the regional average. However, as larger countries generally have lower trade-to-GDP
ratios, a gravity model is estimated to control for size and to analyze the degree to which
Indonesia is integrated into world trade. The paper also examines the extent to which
Indonesia is financially integrated in the region. In this context, the extent of cross border
banking and portfolio flows within the region are assessed.
B. Regional Trade Integration
Trends in Trade Integration
8. The Indonesian economy remains one of the least integrated into world trade
among emerging market countries (EMCs) in Asia. Actual trade openness,2 as measured
by the ratio of export plus imports to GDP, is 350
Figure II.1. Trade Openness
around 50 percent, compared to an average of 300 (Exports plus imports as a percentage of GDP)
250
130 percent for ASEAN countries.3 200
1990-1995
1995-1999
(Figure II.1). Historically, many Asian 150 2000-2006
economies have relied on an export oriented 100

50
development strategy and continue to rely 0
heavily on trade. Indeed many countries have
a
na
a
N
m
a
nd
R
ne
di
re
si
si
EA
SA
na
hi
la
ay
ne
In
Ko
pi
openness ratios in excess of 100 percent,

C
ai
et
AS
al
ng
do
ilip
Th
Vi
Ko
In
Ph
including Hong Kong SAR, Malaysia, g

on
H
Sources: IMF, World Economic Outlook ; and Fund staff calculations.

Singapore, Thailand, and Vietnam.
Furthermore, while the degree of integration has risen significantly for most EMCs in Asia, it
has remained stagnant in Indonesia since the mid-1990s. Larger countries generally have
lower trade-to-GDP ratios, however, the next section will show that the lower level of
integration is not due to Indonesia’s large size.
1
Prepared by Sonali Jain-Chandra (PDR).
2
This measure of trade openness is unconditional on the determinants of trade.
3
Unweighted average of the 10 ASEAN countries.
5
9. Asia remains an important trading partner for Indonesia, accounting for around
60–65 percent of Indonesian exports and imports in 2005 (Table II.1). While industrial
Asia’s, including Japan’s, share in Indonesia’s trade has diminished over time, that of
Table II.1. Indonesia's Trade Integration with Asia
Indonesia's imports from: Indonesia's exports from

(In percent of total Indonesian imports, (In percent of total Indonesian
average) exports, average)
1990-95 1996-99 2000-05 1990-95 1996-99 2000-05
Asia 54.9 54.3 61.3 64.0 60.5 64.1
Non Industrial Asia 25.8 30.0 41.8 30.3 34.3 38.8
Brunei Darussalam 0.0 0.0 0.6 0.1 0.1 0.0

Cambodia 0.0 0.0 0.0 0.1 0.1 0.1
Hong Kong SAR 0.9 0.8 0.7 2.7 3.4 2.1
India 0.9 1.4 1.9 0.3 1.3 2.5
Korea 6.2 5.7 5.4 6.3 6.3 7.2
Lao PDR 0.0 0.0 0.0 0.0 0.0 0.0
Malaysia 1.7 3.0 3.5 1.5 2.5 3.7
Philippines 0.2 0.2 0.4 0.7 1.4 1.5
Singapore 6.1 8.1 12.8 9.4 9.9 9.3
Thailand 1.1 2.7 4.6 1.1 1.7 2.2
Vietnam 0.2 1.0 0.9 0.5 0.7 0.7
China, People's Republic of 3.3 3.9 8.0 3.7 4.0 5.6
Myanmar 0.0 0.1 0.1 0.1 0.2 0.1
Taiwan Province of 5.0 2.9 3.0 3.8 2.7 3.6
Industrial Asia 29.1 24.4 19.5 33.7 26.2 25.3

Japan 23.4 16.9 13.9 31.5 23.2 22.2
Australia 5.1 6.1 5.0 2.1 2.7 2.9
New Zealand 0.5 0.5 0.5 0.1 0.2 0.3
Source: IMF, Direction of Trade Statistics.

6
Emerging Asia has increased. China, Malaysia, Singapore, and Thailand have become
increasingly important trading partners for Indonesia.4
10. Intraregional trade in Asia has

risen since the early 1990s, including for 85
Figure II.2. Intraregional Trade within Asia 1/
80 (In percent of total trade)
Emerging Asia as a whole and for
75
Indonesia. Intraregional trade accounts for 70
ASEAN 4
Emerging Asia
Indonesia
about 57 percent of Emerging Asia’s total 65 Indonesia non fuel trade
trade, whereas it accounts for about 64 60
percent of Indonesia’s trade (Figure II.2). 55
50
Furthermore, in the case of Indonesia, the
05
96
99
00
01
02
03
04
90
91
92
93
94
95
97
98
share of intraregional trade has risen
20
20
20
20
20
20
19
19
19
19
19
19
19
19
19
19
Source: IMF, Direction of Trade Statistics .
steadily, though the share of non-oil 1/ Intraregional trade is defined as the sum of exports to and imports from Asia
as a percent of total exports and imports.
intraregional trade has fallen since peaking
in the late 1990s.
11. Despite the recent robust export 8 60

Figure II.3. Market Shares for Selected Economies
growth, Indonesia’s export performance 7 (In percent)
50
relative to its regional competitors has not 6 Indonesia
China 40
improved. Indonesia has lost market share 5 ASEAN 4
Asia, RHS
Emerging Asia, RHS
4 30
(from 0.97 percent of total world trade in
3
2000 to 0.95 in 2006) (Figure II.3). 2
20
Moreover, it has lost market share in both 1

10
non-oil exports and manufactured products 0 0
since 2000. Of its key export markets,

91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
accounting for 85 percent of total exports, Sources: IMF, Direction of Trade Statistics ; and Fund staff calculations.
Indonesia has lost market share in Japan, the Figure II.4. Change in Indonesia's Export Composition Relative to World Trade, 2000 - 2005
US, and China, while gaining in other
(In percent)
100
Commodities for which Commodities for which
the share in total world the share in total world
emerging markets such as Korea, Malaysia, exports decreased and
Indonesia's exports
80 Copper
exports increased, and
Indonesia's exports
gained market share. 60 Vegetable oils gained market share.
India, Singapore, Taiwan Province of China,
Indonesia's market share
40 Rubber
and Thailand. Using disaggregated trade 20

Natural gas
Coal
data from Comtrade, the change in the -60 -40 -20

0
0 20 40 60 80 100
market share of Indonesian exports in its 20 -20 TV recorders

Copper Ores
Commodities for which -40 Petroleum
most important export categories with a the share in total world Commodities for which the
exports decreased and share in total world exports
Indonesia's exports lost -60 increased, and Indonesia's
change in the market share of these products

Veneers/plywood exports lost market share.
market share.
-80
World share of a particular commodity
in world trade were compared (Figure II.4). Sources: WTO, WITS database ; and Fund staff
Indonesia has increased its market share in only four commodities whose global market share
has risen, specifically coal, copper, rubber, and vegetable oils. In other products categories,
4
Includes Australia, Japan, and New Zealand.
7
Indonesia either lost market share (including textiles, computer equipment, oil and natural
gas) or gained market share in products with a declining share of world trade, contributing to
stagnating market penetration.
12. The low level and unfavorable trend 20

Figure II.5. Composite Measure of Tariffs and Non Tariffs
of integration is not explained by a 18
relatively restrictive trade policy, but rather 16

14 Composite Measure of Tariffs and Non Tariffs
by supply constraints. In fact, measures of de Average tariff
12
jure openness indicate that Indonesia is a 10
relatively open economy. On both average 8
tariffs and a composite measure of tariffs and 6

4
non tariffs, which include measure of tariffs
Philippines
Philippines
Singapore
Cambodia
Indonesia
Myanmar
Lao PDR
Malaysia
Malaysia
ASEAN4
Thailand
Vietnam
ASEAN
Brunei
2
Japan
Korea
China
and non tariffs, Indonesia appears to be an 0
open economy relative to other countries in the Source: Fund staff calculations.
region (Figure II.5).
C. Gravity Model: Does Indonesia Undertrade Within Asia?
13. A gravity model is estimated to assess Indonesia’s integration into the world
economy, relative to the trade potential. The gravity model relates the actual bilateral trade
between two countries to size (GDP), the level of development (proxied by GDP per capita),5
and the distance between the two countries. Recently the standard gravity model has been
augmented by a number of trade resistance variables to predict bilateral trade. Finally,
predicted and actual bilateral trade are compared to arrive at a measure of undertrading or
overtrading relative to potential.
14. The theoretical underpinnings of the gravity model are based on the framework
of Anderson and van Wincoop (2003). The model assumes that each country produces only
one good, consumers exhibit homothetic preferences, with a constant elasticity of
substitution (CES) utility function, and a standard budget constraint. Imposing a market
clearing condition, they show that the gravity equation can be written as follows:
yi y j rij
xij = ( ) (1−σ ) (1)
yw Pi Pj
Where, xij refers to the demand for imports of country i’s goods from country j’s consumers,
Pi and Pj refers to consumer price indices for i and j, yi and yj refers to the total incomes of i
5
Frankel (1997) shows the demand for variety increases with income leading to greater intra industry trade and
higher overall trade.
8
and j, σ is the elasticity of substitution between goods from different countries, yw is the
nominal world income and rij is the trade resistance term.
Taking logs, using total trade as the dependant variable, and augmenting the standard gravity
equation with the a number of trade resistance variables, a gravity model of the following
form widely used in the literature is estimated:
logtijt = α + β1 log(yit y jt ) + β2 log(GDP/ Pop)it + β3 (GDP/ Pop) jt + δi log(Distij ) + δ 2Comlangij + δ 3Colonyij +

(2)
+ δ 4Col45ij + δ5Contigij + δ6Curcolij +δ 7 Smctryij + τ t + ε ijt
Where, tijt refers to the bilateral trade between countries i and j at time t, GDP/Popit refers to
the per capita income in country i at time t, Distij refers to the distance between countries i
and j, and εijt is the white noise disturbance term. We augment the basic gravity model with
dummy variables to control for other trade resistance factors: contig refers to whether two
countries are contiguous, comlang refers to whether they share a common language, colony
refers to whether they have ever had a colonial link, col45 refers to whether two countries
have had a common colonizer after 1945, and smctry refers to whether the two countries
were ever the same country. The gravity model is estimated for 180 countries in a panel from
1990 to 2006, with bilateral trade data drawn from the IMF’s Direction of Trade Statistics.
The data on macroeconomic variables is from the IMF’s World Economic Outlook and the
data on geographical and other trade resistance variables is from the Centre d’Etudes
Prospectives et D’Informations Internationales (CEPII). Random effects estimation is used ,
as using fixed effects panel estimation would eliminate the important time invariant dummy
variables and the distance variable. A time dummy to control for common shocks is also
included.
15. In line with recent advances in the literature, alternate specifications of the
gravity model are also estimated. Recent applications of the gravity model use imports6
from country i to j instead of total trade to avoid the assumption that imports and exports
follow the same pattern (Subramanian and Wei, 2007). This allows the introduction of
importer and exporter fixed effects for all countries in the sample, which attenuates the
omitted variable bias by controlling for all country specific characteristics not explicitly
included in the regression. The second specification is of the following functional form:
logimijt = α + β1 log(yit y jt ) + β2 log(GDP/ Pop)it + β3 (GDP/ Pop) jt + δi log(Distij ) + δ 2Comlangij + δ 3Colonyij +

(3)
+ δ 4Col45ij + δ5Contigij + δ 6Curcolij +δ7 Smctryij +ηi + γ j + τ t + ε ijt
6
Imports are used since data on imports is typically better than export data.
9
16. The bilateral trade dataset includes a number of zero trade observations for
countries that do not trade. Since the model is in logs, many applications of the gravity
model simply omit the zero trade observations. However, omitting zero trade observations
essentially truncates the distribution at zero and leads to a bias. Other solutions for dealing
with zero trade observations include replacing the zero observations by an arbitrarily small
number. Regressions using both methods are estimated with little impact on the direction of
the results. In addition, a non linear random effects Tobit model is estimated, which includes
the zero trade observations thus taking into account truncated distributions.
17. Table II.2 presents the results of the regressions. The sign of the coefficients are
in the right direction, and significant for most variables. Specifically, the coefficients on
the economic size and the level of development are positive, while that on the distance
between countries are negative. Dummy variables capturing the colonial links, common
language, contiguous countries are all positive and significant. The regression with imports
as the dependant variable also includes exporter and importer specific dummies for each
country.
Table II.2. Panel Estimation of the Gravity Model.
1 2 3 4
Log (trade) Log (trade) Log (trade) Log(imports)
Log(GDPi) 1.72 2.01 1.08 2.84
(363.08)** (108.59)** (107.46)** (23.82)**
Log(GDPj) 1.74 1.75 0.92 0.22
(369.87)** (90.66)** (91.99)** (11.85)**
Log (GDPpercapi) 0.31 0.13 0.25 2.27
(47.14)** (5.17)** (18.97)** (18.56)**
Log (GDPpercapj) 0.17 0.17 0.17 0.23
(25.13)** (6.88)** (13.75)** (11.92)**
Log (Dist) -2.07 -2.10 -1.39 -1.63
(169.74)** (42.21)** (53.33)** (73.74)**
Contig 0.37 0.17 0.58 0.58
(5.09)** -0.55 (3.86)** (5.54)**
Comlang 1.65 1.77 0.57 0.65
(59.90)** (15.64)** (9.55)** (12.96)**
Colony 0.57 -0.91 0.95 0.39
(4.36)** -1.69 (3.58)** (2.13)*
Comcol 1.86 2.30 0.52 0.92
(58.33)** (17.61)** (7.32)** (15.49)**
Curcol 3.23 -4.16 -0.56 -2.68
(5.41)** -1.67 -0.45 (3.18)**
Col45 2.96 2.69 1.22 1.39
(18.15)** (4.02)** (3.69)** (5.92)**
Smctry 2.11 2.37 0.64 0.57
(21.81)** (5.87)** (3.12)** (4.00)**
Constant 3.84 3.11 6.82 5.17
(35.33)** (7.05)** (29.70)** (6.32)**
Method of estimation Pooled OLS Random Effects RE Tobit Random Effects

Importer and exporter dummies no no no yes
Time dummies yes yes yes yes
Regional dummies yes yes yes yes
Dummy for commodity producer yes yes yes yes
Observations 448322 227018 150564 131572
Number of id 13732 12081 22323
Absolute value of z statistics in parentheses.
* significant at 5 percent; ** significant at 1percent.
10
Table II.3. Indonesia: Actual Versus Predicted Trade

(In billions of US$, average 2000-2005)
Table II.3 presents the comparison of actual Deviation
trade and predicted trade patterns for Actual

trade
Predicted
trade
from actual
trade
Indonesia. It is found that Indonesia undertrades Total 118.0 211.9 -93.9
with the world economy by around US$90 billion Asia 77.3 123.1 -45.9
or around 40 percent below potential Australia 4.2 3.1 1.1

Brunei Darussalam 0.5 0.0 0.5
trade(average 2000–06), after controlling for size, Cambodia 0.1 0.0 0.1
China,P.R.: Mainland 8.8 16.9 -8.2
the level of development and geography.7 Hong Kong SAR 1.9 0.9 0.9
Indonesia undertrades with the US, EU, and rest India

Japan
2.8
21.2
2.5
81.7
0.3
-60.4
of Asia, specifically with China and Japan, while Korea
Lao People's Dem.Rep
7.6
0.0
3.8
0.0
3.7
0.0
it overtrades with countries in Latin America, the Malaysia
Myanmar
4.5
0.1
4.0
0.0
0.5
0.1
Middle East and Africa. While the precise New Zealand
Philippines
0.5
1.3
0.0
0.3
0.4
1.0
magnitude of the degree of undertrading needs to Singapore
Taiwan Prov.of China
15.4
3.7
6.7
1.9
8.7
1.8
be interpreted with caution, the direction of the Thailand 3.9 1.3 2.6
Vietnam 0.9 0.1 0.8
deviation from trade potential, i.e., the presence of
ASEAN 4 9.7 5.5 4.2
undertrading suggests significant room to increase ASEAN 10 26.7 12.3 14.4
integration with the world economy and the United States 12.2 56.2 -44.1
EU 11.3 22.5 -11.2
region.
Source: IMF Direction of Trade Statistics , Fund staff estimates.
18. In particular the results of the gravity model suggest that there is considerable
undertrading with Japan and the US, and to some extent with China and the EU. It is
with respect to these countries that Indonesia’s export market share has fallen since the
mid-1990s. The structure of Indonesia’s exports reveals the reasons for the undertrading with
these countries. Indonesia exports mostly manufactures to the US, and in concert with a
declining share in world manufactures, the market share in the US has declined, reflecting
increased competition from China and Vietnam. Exports (value terms) of mineral fuels to
Japan (which constitute more than 50 percent of exports to Japan) were falling until the
uptick in 2005, but have rebounded following the rising commodity prices.
50
Figure II.6: Change in Degree of Under-trading or Over-
19. The gravity model can also be used to 30 trading
( f S )
10
analyze the changes in trade integration over -10
time. Comparing the difference between the -30
-50
actual and predicted levels of total trade over y = -5.6036x + 17.935
-70
time suggests that the degree of undertrading has -90
Under-trading
increased in Indonesia (Figure II.6). This is due -110

-130
to of Indonesia’s diminishing export market -150
share since the mid 1990s. 1994 1996 1998 2000 2002 2004 2006
Source: Fund staff calculations.
7
Other East Asian countries overtrade with respect to their trade potential.
11
20. The gravity model possibly underestimates the degree of undertrading as it does
not include the effects of restrictive trade policies. Previous research (IMF, 2002) has
shown that coefficients on the measure of the degree of restrictiveness in the gravity model
will be negative and significant. If we include the restrictiveness measure Indonesia’s
undertrading would be greater than in the baseline gravity model.
D. Impediments to Increased Integration
21. Indonesia’s relatively low trade integration can in part be explained by the fact
that Indonesia has not taken advantage of the growing vertical specialization of global
production (Athukorala, 2006a). International product specialization, or the fragmentation
of production and assembly within vertically integrated production processes across borders,
has contributed to significant increases in trade integration (Hummels, Ishii, and Yi, 2001),
particularly in East Asia. East Asia’s market share of world trade in intermediate goods such
as parts and components was the largest among developing countries (around 39.5 percent of
exports of these goods in 2000), of which Indonesia’s share is relatively small (0.5 percent).
Using disaggregated data, it has been shown that in 2003–04 parts and components
accounted for 9.1 percent of exports from Indonesia, compared with 36.3 percent in
Malaysia, 59.6 percent in the Philippines, 45.2 percent in Singapore and 20.5 percent in
Thailand (Athukorala, 2006b).
22. FDI has played a significant role in the rapid expansion of vertical specialization
in East Asia (Fukao, Ishido,and Ito, 2003). Reflecting the deficiencies in the business
climate (see below), investment- both foreign and domestic- has been lackluster. FDI into
Indonesia remained significantly lower than most other countries in the region (as a percent
of GDP) in the aftermath of the crisis, to pick 8
Figure II.7. FDI Inflows into Asian Countries
up moderately in 2005 (Figure II.7). Domestic 6
(In percent of GDP)
investment in Indonesia also lags, and has 4

historically lagged, other Asian countries
2
(Figure II.8). Detailed analysis at the sectoral
level suggests that share of investment into 0
sectors such as mining, metals, chemicals and -2

Indonesia Korea Philippines
Thailand India China
paper, is not commensurate with their share in -4
total exports (Appendix Table 1, Figure II.9). 1990 1992 1994 1996 1998 2000 2002 2004 2006
Source: IMF, World Economic Outlook .
12
50
Figure II.8. Investment in Asian Countries Figure II.9. Relationship Between FDI and Trade
45
(In percent of GDP) 20 (In percent of GDP)
40
15
35
30
10
FDI
25
20 Thailand
5 Malaysia
15 Indonesia Korea Philippines China
Thailand India China Indonesia Philippines
10 0
1990 1992 1994 1996 1998 2000 2002 2004 2006 0 50 100 150 200 250
Trade
Source: IMF, World Economic Outlook . Source: IMF, World Economic Outlook .
23. Survey based indicators of the business climate are useful to identify the
structural impediments to increased international integration. Indonesia ranks 135 out of
175 countries according to the World Bank’s Doing Business database, while the
International Institute for Management Development (IMD) and the World Economic
Forum’s Global Competitiveness Report place 160 Figure II.10. Comparison of Competitiveness Rankings, 2006 1/
it as the lowest among selected Asian 140
120
countries (Figure II.10). However, the recent 100
approval of the investment and tax 80
administration laws, as well as other reforms

Hong Kong SAR
60
Taiwan POC
planned by the authorities, could be expected 40
Philippines
Singapore
Indonesia
Malaysia
Thailand
Korea
20
China
to change that.
India
0
World Bank- Doing Business
-20 IMD
These surveys point to specific constraints -40
World Economic Forum- Global Competitiveness Report
posed by the investment climate: 1/ Higher rank implies a worse investment climate.
• According to the IMD, Indonesia scores worse on business and government

efficiency, infrastructure, and economic performance, with the infrastructure seen as
the most important obstacle (Figure II.11).
• The World Economic Forum’s Global Competitiveness Report cites the following as
the most problematic factors in the business climate (in order of importance): the
inadequate supply of infrastructure, inefficient government bureaucracy, policy
instability, tax regulations, inadequately educated workforce, and restrictive labor
regulation.
• More specifically, according to the World Bank’s Doing Business database, it takes
longer to start and close businesses, labor markets are more rigid, and it is more
costly to enforce contracts, compared with other countries in the region (Figure II.12).
13
Figure II.11. Elements of Competitiveness, 2006 Figure II.12. Ranking of Various Aspects of the Business Climate, 2006 1/
Infrastructure Starting a business
80 180
60
Singapore
120
40
China
20 Closing a 60 Rigidity of
Economic business employment
0 Business efficiency
performance 0
ASEAN 4 East Asia
ASEAN 4
Indonesia
Indonesia NIEs
Government efficiency Enforcing contracts Registering property

Source: World Bank, Doing Business database.
Source: IMD, World Competitiveness Yearbook, 2006 . 1/A higher rank implies a worse business climate.
E. Has Finance Followed Trade?: Trends in Regional Financial Integration
24. The linkages between trade and Table II.4. Financial Integration in Selected Countries
financial integration has been shown in a Liabilities to GDP Assets plus liabilties to GDP
number of empirical studies (Fukao, 1990 2005 1990 2005
Ishido, and Ito, 2003; Lane and Milesi- Argentina

Brazil
48.3
34.1
85.8
64.1
84.3
45.1
178.7
87.7
Ferretti, 2000, Rose and Spiegel, 2002). Brunei

Cambodia 1/
...
84.9
...
113.1
...
96.0
...
180.2
Financial integration refers to the extent to China

India
19.3
27.7
43.5
35.7
38.9
29.9
97.8
56.9
which domestic savings can be mobilized Indonesia

Hong Kong SAR
59.3
617.5
63.2
593.9
72.9
1435.2
88.2
1434.9
across national borders to achieve a more Lao PDR 2/

Japan
205.9
50.3
150.0
60.3
215.3
111.4
170.4
153.9
efficient allocation of capital, leading to Korea

Malaysia
20.4
69.9
68.0
102.5
35.5
121.6
116.7
196.8
lower cost of capital and higher returns. It Myanmar 2/

Philipinnes
200.3
77.7
112.3
90.3
214.7
95.0
121.7
131.6
can be measured by looking at bilateral cross Russia 1/

Singapore
64.1
166.8
69.9
408.9
110.1
363.5
133.8
1004.4
border financial flows and stocks relative to Turkey

Thailand
39.5
50.0
76.0
75.4
48.9
68.8
104.9
121.6
the rest of the world. Analogous to trade Vietnam 3/ 83.8 76.5 96.2 104.0
ASEAN 10 102.1 143.3 147.6 270.5

integration, financial integration with respect ASEAN 4 64.2 82.8 89.6 134.6
to the world is usually measured as the share Source: Lane and Milessi Feretti, 2007.
1/ 1993 data.
of foreign assets and liabilities as a percent 2/ 2004 data. 2005 not available.
3/ 1995 data.
of GDP. East Asia’s integration into the
global financial system has increased rapidly in the last two decades (Figure II.13). However,
Indonesia’s financial integration with respect 450
Figure II.13. Financial Integration, 1980-2005 1/
(In percent of GDP)
to the rest of the world declined in the 400
350
aftermath of the crisis, and it remains less 300
integrated into the world economy than other 250

Indonesia
Asian economies (Table II.4 and 200
150
ASEAN 4
East Asia
Figure II.13). 100
50
25. Despite the rapid growth of 0

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
intraregional trade in Asia, regional Source: Lane and Milessi Feretti (2007).
1/ Financial integration is defined as foreign assets plus foreign liabilties as a
financial integration has not kept apace percentage of GDP.
(Cowen, and others, 2006). They argue that cross border financial flows between Asian and
non Asian countries are greater than intraregional Asian flows. In the absence of
14
comprehensive bilateral data on cross border financial flows in Asia, it has been shown that
indirect measures such as correlations of consumption growth of most Asian countries with
other Asian countries are relatively low (Mercereau,2006), implying a low level of
intraregional financial integration.
26. Asia’s cross border portfolio investment also shows that intraregional
integration lags integration into global financial markets. Data on bilateral stocks of
portfolio investment from the IMF’s Coordinated Portfolio Investment Survey (CPIS) show
that the US and EU still constitute a more important source of portfolio investment inflows
for Asian countries than other Asian countries (Table II.5). In the case of Indonesia, the US
and EU account for twice as much portfolio investment from Asian countries (including
Singapore).
Table II.5. Geographic Breakdown of Total Portfolio Assets, 2005
(In percent of total portfolio investment of the recepient country/region)
Investment
from: US EU-15 Asia Emerging Asia Industrial Asia Indonesia
Investment
in:
China 25.6 23.4 43.9 40.2 3.7 0.1

Hong Kong SAR 34.5 36.6 18.0 11.3 6.7 0.0
India 29.7 26.1 7.5 4.3 3.2 0.0
Indonesia 31.8 25.2 26.7 24.7 2.0 0.0
Japan 42.4 41.6 3.6 2.2 1.4 0.0
Korea 51.0 29.7 13.3 9.3 4.0 0.0
Malaysia 22.7 29.2 45.8 42.9 2.9 0.0
Myanmar 0.0 10.1 89.9 89.9 0.0 0.0
Philippines 32.9 45.3 16.0 9.6 6.3 0.0
Singapore 44.8 29.0 17.4 10.7 6.7 0.3
Taiwan POC 51.8 35.7 8.7 7.0 1.7 0.0
Thailand 34.1 35.9 24.5 22.1 2.4 0.0
Vietnam 27.3 62.0 4.4 3.3 1.1 0.0
US ... 40.4 18.3 2.1 16.2 0.0

EU-15 15.2 62.7 7.9 1.6 6.2 0.0
Asia 39.3 36.6 12.7 8.5 4.3 0.0
Emerging Asia 39.3 36.6 19.4 15.3 4.1 0.0
Industrial Asia 39.3 39.8 9.1 4.7 4.4 0.0
Source: IMF, Coordinated Portfolio Investment Survey.
120
Figure II.14. Claims of BIS Reporting Banks on Asia by Region, 2006
(In percent)
100
27. Intraregional cross border banking 80

Malaysia
Singapore
Korea
Philippines
flows within Asia appear to be limited. In 60

ASEAN
India
Indonesia
China
most Asian countries, European, American 40
20
and UK banks constitute a majority of the
0
source of banking flows, with flows from -20
UK Banks US banks European banks Asian banks 1/
Source: Bank for International Settlements.

1/ Asian banks refer to Australian and Japanese reporting banks.
15
other Asian countries on average about 10 percent of the total claims of foreigners8 (Figure
II.14). This suggests that there is considerable scope for enhancing the regional integration of
banking flows. In Indonesia, only 16 percent of banking inflows are from Asian countries.
Eichengreen and Park (2005) study gross cross border banking flows (of BIS reporting
banks), and use a gravity model to conclude that different levels of financial market
development (as measured by bank credit as a share of GDP) compared with other regions
mostly explains the lower financial integration in Asia. Greater intraregional trade within
Europe than within Asia is also an important factor.
F. Conclusions
28. This paper finds evidence that Indonesia is less integrated into world trade and
region, than would be expected based on fundamentals. In order to control for the various
determinants of trade, a gravity model is estimated which provides a measure of predicted
bilateral trade based on fundamentals, and is used to arrive at a measure of undertrading or
overtrading relative to potential. It is found that that Indonesia undertrades relative to its
potential by around US$90 billion, and the degree of undertrading has increased over time.
Furthermore, financial integration has lagged trade integration. The low level of trade
integration can be explained in part by the lack of investment, resulting from the deficiencies
in the business climate, and the limited integration into the global production chains. There is
hence large scope to increase integration with the world and regional economy, which has the
potential to contribute significantly to raising growth and incomes, as it has happened in
much of East Asia.
8
It should be noted that only data on the BIS reporting banks are included. Australia and Japan are the only the
Asian reporting countries for which data are publicly available through the BIS website. The omission of data
on banks from Singapore and Hong Kong presents a significant limitation.
16
REFERENCES
Anderson, J.E., and E. vanWincoop, 2003, “Gravity with Gravitas: a Solution to the Border
Puzzle,” American Economic Review, 93 (1), 170–192.
Athukorala, P., 2006a, “Product Fragmentation and Trade Patterns in East Asia,” Asian
Economic Papers, 4 (3).
Athukorala, P., 2006b, “Post Crisis Export Performance: The Indonesian Experience in
Regional Perspective,” Bulletin of Indonesian Studies, Vol. 42, No.2.
Cowen, D., R. Salgado, H. Shah, L. Teo, and A. Zanello, 2006, “Financial Integration in
Asia: Recent Developments and Next Steps,” IMF Working Paper WP/06/196.
Eichengreen, B. and Y. C. Park, 2005, “Why Has There Been Less Financial Integration in
Asia than in Europe?”, University of California, Berkeley Working Paper.
Frankel, J., 1997, “Regional Trading Blocs in the World Economic System” (Washington:
Institute for International Economics).
Fukao, K., H. Ishido, and K. Ito, 2003, “Vertical Intra-Industry Trade and Foreign Direct
Investment in East Asia,” Institute of Economic Research Discussion Paper Series A,
No. 434.
Hummels D., J. Ishii, and K. Yi, 2001, “The Nature and Growth of Vertical Specialization in
World Trade,” Journal of International Economics, Volume 54, Issue 1.
International Monetary Fund, 2002, “Trade and Financial Integration,” World Economic
Outlook, Chapter 3, pp. 108–146.
Lane, P. R., and G.M. Milesi-Ferretti, 2000, “External Capital Structure: Theory and
Evidence,” IMF Working Paper 00/152
Mercereau, B., 2006, “Financial Integration in Asia: Estimating the Risk-Sharing Gains for
Australia and Other Nations,” IMF Working Paper WP/06/267.
Rose, A. and M. Spiegel, 2002, “A Gravity Model of International Lending: Trade, Default
and Credit,” CEPR Discussion Paper No. 3539.
Subramanian, A and S. Wei, 2007, “The WTO Promotes Trade, Strongly But Unevenly,”
Journal of International Economics, Volume 72, Issue 1, pp. 151–175.
17
III. INDONESIA, 1997 VS. 2007: HOW FAR HAS CRISIS VULNERABILITY BEEN REDUCED?9
A. Introduction
29. Of all the emerging market economies hit by the 1997–98 financial crisis,
Indonesia was most severely affected, and took longest to recover. Output declined by
13 percent in 1998, while the rupiah had lost more than 80 percent of its value by June 1998.
Unemployment, inflation and poverty soared. This happened despite Indonesia’s economy
appearing (at least superficially, based on headline macroeconomic indicators such as the
current account deficit) in better shape prior to the crisis than some of the other affected
countries. However, perhaps more than in any other country, the experience of the crisis
triggered deep-rooted institutional reform.
30. A key question for Indonesia, given the devastating effect of the 1997–98 crisis, is
whether the changes to its economy and institutions in the intervening years have
substantially reduced its crisis vulnerability. The tenth anniversary of the onset of the
crisis provides a good occasion for such an assessment.
31. Financial crises can be caused by a multitude of factors, and the literature on their
genesis is exhaustive (see Allen and others, 2002 and Dornbusch, 2001). However, the
causes can be grouped into four broad but inter-related groups:
• Macroeconomic policies, including unsustainable or mutually incompatible fiscal,

monetary and exchange rate policies;
• Weaknesses in the financial and corporate sectors, including excessive risk-taking by

firms and balance sheet mismatches;
• Contagion as a crisis in another country leads to a collapse in investor sentiment;
• Weak, inefficient or corrupt institutions that can create poor policies, exacerbate
structural weaknesses, and undermine investor confidence, as well as delaying the
response to a crisis once it occurs.
32. The following sections discuss these factors in turn, briefly commenting on their
role in the 1997–98 Asian crisis. Indonesia’s progress in overcoming these vulnerabilities is
then assessed for each set of factors, both in absolute terms and relative to the other countries
affected by the crisis to a greater or lesser extent (Korea, Malaysia, the Philippines, and
Thailand). Overall, Indonesia has made significant progress since 1997, reflecting sound
macroeconomic policies, institutional reform and, in recent years, a benign external
environment.
9
Prepared by Christopher Crowe (ext. 35303), with thanks to Agnes Isnawangsih, Armando Morales, Romaine
Ranciere and Wiwit Widyastuti for help with various data requests.
18
33. Each “generation” of financial crises tends to arise from hitherto unknown or
underappreciated vulnerabilities. The final section therefore considers some new potential
sources of vulnerability as cited by some analysts. In as far as these vulnerabilities can be
quantified, risks here too seem relatively lower in the case of Indonesia relative to many
other countries.
B. Macroeconomic Policies
34. Macroeconomic policies have a central role in both the first and second
generation currency crisis literature (Krugman, 1979; Flood and Garber, 1984; Obstfeld,
1994). The role of macroeconomic policies lies in the tension between domestic and external
policy objectives. In particular, if a country pursues external stability by pegging the
exchange rate, while at the same time attempting to achieve domestic policy objectives via
expansionary monetary, credit and/or fiscal policies, the currency will become overvalued in
real terms and vulnerable to speculative attack.
35. In fact, weak macroeconomic policies are not seen as having played a central
role in any of the Asian crisis countries (except perhaps in as far as policies such as
maintaining a fixed exchange rate encouraged excessive private sector borrowing and poor
risk management in the financial sector). Fiscal policy was conservative: Indonesia ran a
surplus of 0–1 percent of GDP in the run-up to the crisis (Table III.1). While external current
account deficits were quite high in Thailand and Malaysia, Indonesia’s current account
deficit was modest, at just over 2 percent of GDP, while the real exchange rate appreciated
only mildly in the run-up to the crisis (Figure III.1) and did not appear over-valued in
Indonesia (Goldstein, 1998).
Table III.1. Selected Countries: Macroeconomic Indicators, 1992-2006
Indonesia Korea Malaysia Philippines Thailand

1992-96 2002-06 1992-96 2002-06 1992-96 2002-06 1992-96 2002-06 1992-96 2002-06
External Current Account Balance (percent of GDP) -2.2 2.2 -1.6 1.9 -6.0 12.9 -3.8 1.3 -6.3 1.2
Central Government Balance (percent of GDP) 0.0 -1.2 0.0 2.2 0.6 -4.5 -1.3 2.2 2.3 -0.4
M2 (growth rate, percent p.a.) 23.8 11.1 16.3 4.5 17.0 9.8 20.6 9.5 15.9 5.5
M2/GDP (average change, percentage points p.a.) 2.5 -1.6 0.5 -1.3 3.2 -0.7 2.5 -0.4 2.4 -3.1
Inflation 7.8 9.0 5.3 3.0 1.9 2.3 7.8 5.2 4.9 2.3
Source: IMF, World Economic Outlook.
19
36. However, loose credit conditions and a fixed exchange rate encouraged risky
lending (often in foreign currency) in a number of affected countries, which created
vulnerabilities in the corporate and financial sectors (Krugman, 1999). Money and credit
growth was particularly rapid in Indonesia, with broad money growing at almost 25 percent
per year during 1992–96. The M2/GDP ratio, an indicator of financial intermediation,
expanded by around 2–3 percentage points per year, strongly suggestive of a credit boom.
Rapid credit creation interacted with structural weaknesses in the financial sector to create
new vulnerabilities (discussed below), particularly with respect to currency and maturity
mismatches on financial and corporate sector balance sheets. Indonesia also placed itself
open to speculative pressure (as did the other Asian crisis countries) by pegging its exchange
rate.10
37. Current macroeconomic 140

Figure III.1. Selected Countries: Real Effective Exchange Rates
policies in Indonesia are sound. 130 (January 1990 = 100)
Fiscal deficits are modest and debt is 120

declining, the external current 110
account is in surplus, the exchange 100
rate is more flexible (and the real 90
exchange rate is estimated to be 80
Indonesia
Korea
Malaysia
modestly undervalued; see IMF, 70
Philippines
Thailand
2007). While credit expansion has 60
China
picked up recently, the M2/GDP ratio 1990M1 1991M1 1992M1 1993M1 1994M1 1995M1 1996M1 1997M1
has declined to 40 percent (a Sources: IMF, APDCORE database; and Fund staff estimates.
14 percentage point decline since

1998). A steady build-up of reserves and lower external borrowing has reduced the ratio of
short-term debt to reserves to less than half of the pre-crisis level, well below the 100 percent
level implied by the Greenspan-Guidotti rule. However, inflation remains higher and more
volatile than in other regional economies, which could ultimately put pressure on the
exchange rate.
C. Financial and Corporate Sector Weaknesses
38. Rapid credit creation in the first half of the 1990s exacerbated structural
weaknesses, particularly with respect to private sector balance sheets. Much of the credit
expansion was undertaken via overseas borrowing, mostly short term and denominated in
foreign currencies. Moreover, the extent of the rapid build-up in external borrowing only
10
According to the Reinhart and Rogoff (2004) de facto classification, Indonesia’s and Korea’s exchange rate
regimes at end-1996 can be classified as crawling pegs, Malaysia’s as a crawling band (with a tolerance zone of
less than 2 percent around the central peg), while the Philippines and Thailand followed fixed pegs.
20
started to emerge mid-

Table III.2. Short term External Debt
1997, contributing to (In percent of reserves)
the slide in confidence.
Currency mismatch was Indonesia Korea Malaysia Philippines Thailand
encouraged by the 1996 175.1 222.8 40.8 77.4 126.0
exchange rate peg. By 1997 196.4 312.8 71.5 156.6 143.9
2005 73.9 31.3 17.4 39.5 31.5
end-1996, Indonesia’s
ratio of short-term Sources: WB, World Development Indicators ; IMF, International
Financial Statistics ; and Fund staff calculations
external debt to
international reserves was
Table III.3. Non-bank Private Sector Cross-border Borrowing
more than 170 percent (From BIS-reporting banks, percent of reserves)
(Table III.2). Total
borrowing by the nonbank Indonesia Korea Malaysia Philippines Thailand
private sector from 1997 Q2 194.0 92.9 61.6 67.5 131.1
international banks stood 2006 Q3 56.0 20.0 24.9 42.5 18.6
at almost two times Source: BIS Quarterly Review; and IMF, International Financial
reserves in mid-1997 Statistics.
(Table III.3). A significant portion of the foreign borrowing went into sectors, such as real
estate, which tended to earn little or no foreign exchange. Domestic banks were also lending
in foreign currency, which totaled more than 30 percent of total credit outstanding by the end
of 1997 (of which one-tenth went to the property sector; Table III.4). Commercial banks
were also borrowing significantly in foreign currency (including via foreign currency
deposits), with total foreign currency liabilities representing more than 30 percent of total
bank liabilities by end-1997.11 Hence Indonesian banks were doubly squeezed once the crisis
hit: devaluation significantly increased the value of their liabilities, while on the asset side
corporate borrowers defaulted on their foreign currency loans.
Table III.4. Commercial Bank Credit Outstanding, End of Year
1997 2000 2006

Forex Lending, percent of total 30.8 43.3 18.8
Property Lending, percent of total 17.1 10.3 14.7
Forex property lending, percent of total property lending 16.2 23.8 5.6
Forex property lending, percent of total lending 2.8 2.4 0.8
Total Credit Outstanding, Rp. tn. 378.1 269.0 787.1
Source: Bank Indonesia.
39. Lax prudential rules encouraged risky lending, leading to deteriorating asset
portfolios. Prior to the crisis, the ratio of non-performing loans (NPLs) to total loans was
11
Source: CEIC.
21
almost 9 percent in Indonesia (Table III.5).12 High pre-crisis NPLs demonstrated how
connected lending and poor credit-risk management had jeopardized the health of the
banking system. In addition, they made currencies more vulnerable to speculative attack by
increasing the costs of an interest rate defense of the exchange rate anchor.
40. Underlying weaknesses in the financial and corporate sectors helped to create
these financial fragilities. In Indonesia more than half of the corporate sector was controlled
by just 10 families prior to the crisis (IMF, 2006). This concentrated ownership structure
meant that risks were not well diversified, and also contributed to corporate governance
problems (Turner, 2007). Moreover, many large corporate groups owned banks that lent
intra-group significantly in excess of regulatory limits. Post-crisis, around half of lending by
banks that failed and ended up under the control of the restructuring agency, IBRA, was
found to be intra-group (Pangestu and Habir, 2002). Financial regulation and supervision was
perceived to be improving in the run-up to the crisis.13 However, post-crisis it was revealed
that violations of prudential regulation (for instance, with respect to intra-group lending)
were widespread, as was financial misreporting more generally. Partly, this reflected the
concentrated and opaque ownership structure of the banking and corporate sectors, with a
small number of players—well-connected politically—able to manipulate the system.
Politically-connected banks were seen as “too important to fail,” generating moral hazard
problems. Regulatory and supervisory capacity at Bank Indonesia (BI) and elsewhere was
inadequate (Pangestu and Habir, 2002).
Table III.5. Non Performing Loans Ratio

(In percentage points)

1996 8.8 0.8 3.9 n.a. 7.7
Peak, 1997-98 >25.0 >25.0 12.0-25.0 10.0-15.0 >25.0
2005 8.1 1.0 9.6 8.6 9.1
Sources:
1996: BIS, 1997; quoted in Goldstein, 1998
1997-98: Ramos 1998, for Goldman Sachs; quoted in Goldstein, 1998
2005: Financial Soundness Indicators Consolidated Collection Exercise
Except Thailand: April 2007 Global Financial Stability Report
Malaysia: IMF Staff Estimates
12
Substantial financial misreporting means that the pre-crisis NPL measures should be interpreted cautiously;
they are almost certainly underestimates (so that the real improvement in credit quality is higher than that
implied by the figures presented here).
13
For instance, the Economist Intelligence Unit’s assessment of the Indonesian banking sector in the first
quarter of 1997 noted that “Although vulnerable on a number of counts—its poor asset quality, its overexposure
to the property sector and its growing reliance on external funds—the sector is reasonably closely supervised.”
22
41. There have been significant improvements in financial sector regulation and
supervision since the crisis. Regulatory changes in the banking sector tightened rules on,
inter alia, loan classification and provisioning, related-party lending, capital adequacy and
foreign exchange rate risk (IMF, 2004 provides a detailed account of the reforms). There has
also been an improvement in regulatory capacity at BI, and supervision is more regular and
thorough. In addition, the restructuring of insolvent banks post-crisis removed banks from
related corporate groups, helping to solve the related lending problem (IMF, 2006).
42. However, weaknesses remain. In the banking sector, the post-crisis restructuring has
bequeathed a large share of the banking system (more than one third by assets) to state-
owned banks, which generally have weaker financial performance and loan quality, and are
more exposed to the potential for government interference in operational matters (Nasution,
2007). In the corporate sector, disclosure of cross-ownership can still be insufficient, and
financial statements are still not fully consistent with international norms, while ownership
remains concentrated (IMF, 2006).
43. Improvements at the policy and institutional level have been reflected in a post-
crisis recovery in financial and corporate sector indicators. In the banking sector, NPL
ratios have fallen significantly from their crisis peak, and are comparable to other countries
in the region. The corporate sector is less leveraged, with debt-equity ratios having also fallen
back to below the levels in other regional economies (Table III.6), and estimated corporate
default probabilities are low and below the average for emerging market economies (EMEs)
in the region (although this is also the case when a similar calculation is made using 1996
data; Table III.7). However, corporate performance differs by type of company. In particular,
domestic firms with a concentrated ownership structure remain more vulnerable, as they tend
to be both less profitable and more highly leveraged.14 Banks’ capital-asset ratios have
increased significantly (Table III.8).15 However, ratings agencies have been slow to upgrade
their assessment of banks’ underlying financial strength (Table III.9).16 Ratings for
Indonesian banks have improved more than in some countries, but less than in others
(particularly Korean institutions).
14
Domestic firms with more than 40 percent of equity held by a single family or group have a debt/equity ratio
of 144 percent and a return on assets of 0.3 percent, compared with an average of 109 percent and 1.4 percent
(respectively) in the sample as a whole (the top 100 nonfinancial firms listed on the Jakarta Stock Exchange,
data for 2005; Source: Worldscope database).
15
However, Indonesia’s high Capital Asset Ratios are partly the result of the illiquidity of the recapitalization
bonds on the banks’ balance sheets, which encourage holdings of additional liquid assets, primarily SBIs
(Nasution, 2007).
16
Fitch’s Individual Ratings represent Fitch’s assessment of the probability of a bank requiring financial
support. Ratings vary from A through E (where E represents the greatest risk). The number of banks in each
sample is shown in parentheses. Turner (2007) presents the Fitch ratings for end-1998 and end-2005, in addition
to ratings by Moody’s which show a very similar picture.
23
Table III.6. Corporate Debt as Percentage of Equity 1/
Indonesia Korea Malaysia Philippines Thailand Japan USA

1996 95.2 267.5 100.4 76.0 165.9 194.3 140.9
1998 453.6 313.7 112.5 86.1 352.2 187.7 172.3
2004 80.5 115.4 98.2 124.3 100.3 200.3 145.3
Source: IMF, Corporate Vulnerability Utility database.
1/ Weighted by capitalization
Table III.7. BSM Probability of Default
Indonesia Korea MalaysiaPhilippines Thailand Asia EMEs (avg.)

1996 0.4 9.0 1.0 0.0 0.0 1.6
2005 0.7 0.4 2.3 0.6 0.6 0.8
Source: Fund staff estimates.
Table III.8. Bank Regulatory Capital
(In percent of risk weighted assets)

1995 1/ 11.9 9.3 11.2 n.a. 9.3
2006 2/ 19.2 13.3 12.7 17.6 3/ 14.3
Sources: Turner (2007); and IMF, Global Financial Stability Report April 2007.
1/ 1995 CARs can be regarded as overestimates, since inadequate provision made for impaired loan
2/ 2006 CARs: September (Indonesia and Korea); November (Malaysia and Thailand).
3/ Data for 2005.
Table III.9. Selected Countries: Fitch Individual Ratings on Banking Sector

1998 1/ E (3) E to D/E (8) D/E to D (6) D to C/D (5) E to D/E (12)
2007 2/ D to C/D (12) C to B/C (14) D to B/C (11) D/E to C/D (13) D to B/C (10)
Source: Turner (2007) and Fitch Research.
1/ as of December.
2/ Most recent ratings, generally January - May 2007.
44. There also appears to be less exposure to devaluation risk via international
borrowing in foreign currency. International bank lending (from BIS reporting banks) to
Indonesian entities (public and private sector, including banks) remains below pre-crisis
levels (Table III.10). Moreover, the proportion of such lending undertaken via local affiliates
in local currency—as opposed to cross-border or locally in foreign currency—has quadrupled
to around one-third, implying significantly lower currency mismatch for local borrowers.
However, this proportion has increased even more markedly in Korea, Malaysia, and
24
Thailand. International borrowing by the nonbank private sector has declined from almost
two times reserves in mid-1997, to just over one-half more recently, although the level of
borrowing, as a proportion of reserves, remains the highest of the Asian crisis countries.
Table III.10 Lending to Selected Asian Countries by BIS- Reporting Banks 1/

Total Local Total Local Total Local Total Local Total Local
(US$ bn.) (percent of total) (US$ bn.) (percent of total) (US$ bn.) (percent of total) (US$ bn.) (percent of total) (US$ bn.) (percent of total)
1997 Q2 63.5 7.5 113.5 8.9 37.5 23.1 19.3 26.8 78.5 11.7
2006 Q3 54.2 28.7 286.5 50.7 89.5 56.4 26.8 19.9 51.1 56.5
Source: Bank for International Settlements Quarterly Review (December 1997 and March 2007).
1/ Total: international claims (cross-border loans plus local loans in foreign currency) plus local loans (made through local affiliates in local currency).
Local: local currency loans made by local affiliates.
D. Contagion
45. Contagion is seen as a critical component of the Asian financial crisis (Baig and
Goldfajn, 1998; Berg, 1999; Goldstein, 1998). For Indonesia, where macroeconomic
fundamentals were largely benign and structural weaknesses did not show up until the crisis
had broken out, contagion likely played a large role. Contagion (from country A to country B
can occur via three channels (Goldstein, 1998): (i) direct real effects via bilateral trade and
investment flows between countries A and B, (ii) speculative pressure on country B’s
currency as the devaluation in country A undermines B’s external competitiveness, and (iii) a
“wake up call” to investors as the perceived risks to investors in country B increase in
response to the crisis in country A.
46. Direct trade flows within East Asia were fairly limited prior to the crisis
(Goldstein, 1998). Investment flows, though harder to quantify, were likely equally
insignificant. Competitive devaluation pressure could have played a role for some countries,
although perhaps less so in Indonesia’s case, due to less direct export competition in third-
country markets. The “wake up call” view seems more plausible: market perceptions of risk
across the region were excessively sanguine in the run-up to the crisis (reflected in stable or
improving sovereign credit ratings and declining spreads). The onset of the crisis led to a
rapid reassessment of risks and speculative pressure on the rupiah quickly mounted.
47. Indonesia may have become more vulnerable to contagion from other regional
economies, principally via the investor sentiment channel. The potential for contagion via
other channels has also increased, but remains small.
• Bilateral trade flows remain relatively low but have increased (Table III.11).
• Competitive devaluation remains an unlikely potential source of contagion, but here

again risks have increased somewhat. Indonesia’s export composition continues to
differ from those of its principal regional competitors. According to the export
similarity indices presented in Table III.12 (which vary between 0 and 100 and
increase in export similarity), Indonesia’s export pattern remains the most specialized.
However, it has become a little more similar to those of regional counterparts over
time.
25
• Regional financial markets are more integrated. To illustrate this increased

integration, the Table III.13 shows the comovement of daily stock market returns in
Indonesia and other regional economies during 1995 (pre-crisis), 1997–98 (the crisis
period) and 2005–06 (to show recent behavior).17 Greater comovement in stock
returns is taken as evidence of greater market integration, creating heightened
contagion risks.
Table III.11. Indonesian Exports

(In percent of total exports)
1996 2005
ASEAN5+Korea 21.0 25.7
Korea 6.6 8.3
Malaysia 2.2 4.0
Philippines 1.4 1.7
Singapore 9.1 9.2
Thailand 1.6 2.6
Hong Kong SAR 3.3 1.7
China 4.1 7.8
Industrial Countries 58.5 48.0
Source: IMF, Direction of Trade Statistics.
17
The comovement measure shown here is the unconditional correlation coefficient (Forbes and Rigobon,
2002) which attempts to control for the impact of heteroskedasticity (in periods of greater volatility, the
correlation coefficient will tend to increase even if the underlying correlation structure does not change). The
assumptions necessary for the unconditional correlation coefficient presented here to be unbiased are unlikely to
be met; however, it is likely to be a less biased measure than the conditional correlation coefficient. The original
data series are the daily stock market return (using the main stock market index for each country, in U.S. dollar
terms). Contemporaneous correlations are obtained from the variance-covariance matrix of the errors from
bivariate VARs run with 5 lags. Dummies for market closures in either market and returns on the New York
market (current and lagged to 5 days) are included as controls (the latter controls for the influence of common
shocks that influence both markets, which is distinct from spillovers from one market to the other). If ρ* is the
conditional correlation coefficient between the shock to stock returns in country A (assumed the source of
contagion) and country B (assumed the victim of contagion, in this case Indonesia) then the unconditional
correlation coefficient is given by:
ρ* ⎛ σ A2 0 ⎞
ρ= ; where ⎜ ⎟
⎜ σ 2 −1⎟ denotes the change in the variance of the stock return in
⎛σ 2 ⎞
(
1 + ⎜⎜ A20 − 1⎟⎟ 1 − ρ *
2
) ⎝ A1 ⎠
⎝ σ A1 ⎠
country A between the (low-variance) pre-crisis period 0 and the high-variance crisis period 1. In the
calculations presented here, for comovement with respect to Indonesia, country A is the country denoted in the
first row of the table and country B is Indonesia; period 0 is 1995, while period 1 is either 1997–98 or 2005–06.
26
Table III.12. Export Similarity, Indonesia and Selected Economies, 1996 and
2005
Indonesia Korea Malaysia Philippines Thailand China
1996 Export Similarity Index
With respect to Indonesia ... 28.6 36.4 25.4 36.5 35.5
Average with respect to all 32.5 36.8 40.9 37.9 41.9 37.0
other 5 economies
2005 Export Similarity Index
With respect to Indonesia ... 25.6 41.6 26.5 40.0 36.3
Average with respect to all 34.0 37.6 43.8 34.9 43.3 40.6
other 5 economies
Source: Comtrade, via WITS, and IMF Staff Calculations.
Notes: 18
Table III. 13. Estimated Comovement of Daily Stock Returns, Indonesia and
Selected Countries.
Hong Kong Korea Malaysia Philippines Singapore Thailand Average

1995 .39 .08 .40 .46 .47 .38 .37
1997-98 .19*** .02 .13*** .21*** .25*** .14*** .16
2005-06 .57*** .37*** .65*** .28*** .59*** .32 .47
Sources: Bloomberg, Datastream, and Fund staff calculations.
***
: signifies that corrected correlation coefficient is significantly different from the 1995
measure at the 1 percent significance level (only with respect to individual countries).
Average is unweighted mean for all six countries.
¾ According to this measure, comovement generally declined during the crisis period,
possibly reflecting the rather different patterns of crisis and recovery in the different
countries.
¾ The degree of comovement in 2005–06 is generally higher than during either the pre-
crisis or crisis periods (for Indonesia and most of the other countries). This would
tend to suggest that Indonesia’s vulnerability to contagion has increased.
18
Following Finger and Kreinin, 1979, the Index of Export Similarity is defined as:
S (ab, c ) = 100.∑ Min.[X i (ac ), X i (bc )] where a and b are the two countries whose export patterns are
i
being compared, c is the third market (in this case, the world), and Xi(ac) etc. is the share of good i in country
a’s total exports to market c. Goods are defined using the 4-digit SITC code. The average is a simple
unweighted mean.
27
E. Institutions
48. In many of the Asian crisis economies there were very close links between
governments, banks and large corporations in their very successful growth phase in the
run-up to the crisis (Wyplosz, 2007). In Indonesia, banks were often owned by corporate
groups with strong political connections (Hill and Shiraishi, 2007). The resulting problems of
connected lending, poor credit quality and weak supervision undermined the banking sector
and contributed to its collapse in 1997–98 (see section C). In addition, links between
particular banks and political groups meant that political instability could trigger bank runs
which were only halted when the banks’ assets were taken over by IBRA (Pangestu and
Habir, 2002). Generally, these problems, which were well-known prior to the crisis, were
reflected by high perceived levels of corruption (Table III.14).19
Table III.14. Corruption Perception Index Rankings

(Percentile)
Indonesia Korea Malaysia Philippines Thailand China India Coverage

1996 83.3 50.0 48.1 81.5 68.5 92.6 85.2 54
1998 94.1 50.6 34.1 67.1 75.3 61.2 80.0 85
2006 82.2 26.4 27.0 77.3 39.9 43.6 45.4 163
Source: Transparency International.
49. Since the crisis, the institutional Table III.15. Selected Countries: Risk Ratings
(Rating from 0 to 100)
environment in Indonesia has
improved significantly (Hill and Indonesia Korea Malaysia Philippines Thailand
Shiraishi, 2007). Political reforms to Overall Political Risk Rating

decentralize power have complimented Jan-May 1997
Peak, 1998-99
33.0
60.0
18.8
28.0
21.4
34.0
31.2
31.0
24.8
34.0
improvements to financial regulation and Jan-May 2007 39.5 27.5 23.6 38.5 42.9
supervision outlined in Section C, helping Corruption

Jan-May 1997 50.0 33.3 33.3 50.0 50.0
to reduce vulnerabilities stemming from Peak, 1998-99
Jan-May 2007
83.3
56.7
50.0
58.3
50.0
53.3
50.0
66.7
66.7
75.0
close corporate-political ties. This broad Government Instability
institutional transformation has also been Jan-May 1997
Peak, 1998-99
11.7
58.3
18.3
25.0
8.3
33.3
16.7
33.3
31.7
41.7
associated with decreased perceptions of Jan-May 2007 36.7 62.5 20.8 53.3 40.0
risk and instability, which have fallen Source: International Country Risk Guide.
19
For instance, according to the 1996 Corruptions Perceptions Index (CPI; Transparency International’s survey-
based measure of perceived corruption in a cross-section of countries), Indonesia, the Philippines and Thailand
were perceived to be more corrupt than average (Table III.14). In 1995 Indonesia topped the global survey.
28
furthest from their crisis peak among affected countries (Table III.15). Although concerns
remain with respect to perceived levels of corruption, there has been progress in this area
too.20
F. New Sources of Vulnerability
50. While Indonesia generally appears less vulnerable now with respect to the crisis
risks relevant in 1997, hitherto underappreciated sources of vulnerability tend to
emerge from each new crisis. These are difficult to identify ex ante; however, some
analysts have attempted to identify new potential sources of risk for the economies hit by the
1997–98 crisis.
51. One potential source of risk is the alleged pursuit of policies that do not permit
the exchange rate to appreciate, with the goal of boosting exports and economic growth
(Roubini, 2007). According to this view, undervalued exchange rates can increase
vulnerabilities by encouraging asset price bubbles and a more rapid growth in the money
supply (via only partial sterilization of the reserves build-up and below-equilibrium interest
rates). Asian economies are therefore vulnerable to a growth slowdown outside Asia that
could trigger an export-led slump and rapid reversal of asset prices, leading to a collapse in
confidence and, potentially, second-round effects on the exchange rate, inflation and output.
52. Recent developments in Indonesia are not consistent with this model. Indonesia is
less dependent on export-led growth than many 170
Figure III.2. Selected Countries: Real Effective Exchange Rate
other emerging market countries and the reserve 160 (June 2001 = 100)
150
build-up has been more modest. In addition, the 140
rupiah has shown considerable flexibility in 130
Indonesia Korea
nominal terms. It has also appreciated by more 120 Malaysia
Thailand
Philippines
China
110
than 50 percent in real effective terms in the last 100
six years, though much of the real appreciation 90
reflects above-average inflation (Figure III.2).21 80

2001M6 2002M6 2003M6 2004M6 2005M6 2006M6
Sources: IMF, APDCORE database; and Fund staff estimates.
20
The two sets of corruption indicators presented here give contrasting pictures for the recent period, suggesting
that some caution is needed in interpreting the indicators. The difference reflects in part that the former shows
relative global rankings, while the latter gives absolute scores. Hence, Indonesia’s score has improved recently
in absolute terms, but is less impressive set against a downwards trend in perceived corruption globally.
Moreover, the ICRG scores are more focused on perceived concerns for international investors, whereas the
CPI has a broader civil society focus.
21
The nominal effective exchange rate has also been on an upwards trend since September 2005, appreciating
by around 8 percent (by April 2007).
29
53. As regards asset prices, over the course of the current bull market (dated from the
start of the pick-up in the Hong Kong stock 800
index in October 2002) the U.S. dollar value 700 Figure III.3. Selected Economies: Stock Market Indices
(October 2002 = 100)
of Indonesian stocks has increased by 600
around 400 percent, ahead of other regional 500

Hong Kong
Korea
Philippines
Indonesia
Malaysia
Singapore
stock markets (Figure III.3). However, 400
Thailand
Indonesia’s markets were in large part 300
recovering from the prolonged historically 200
low stock values following the crisis and 100
catching up with the recoveries that 0

Jan-97 Jul-98 Jan-00 Jul-01 Jan-03 Jul-04 Jan-06
occurred earlier in the other crisis countries. Source: Bloomberg.
Good corporate performance and improving

macroeconomic indicators supported the recovery. Nevertheless, in Indonesia price/equity
ratios, while below historical (pre-crisis) levels, are now above those in the other Asian crisis
countries, and still on an upwards trend.22 Hence, while the surge in stock prices does not
necessarily imply the existence of a bubble, it does create the possibility of a reversal.
54. The recent pick-up in the volume of portfolio inflows has been of concern to the
authorities. In particular, the short-term nature of the inflows creates a worry that, as in
1997–98, they could be quickly reversed, leading to a collapse in asset prices and a loss of
reserves. However, inflows have largely been into liquid government and central bank
certificates, rather than illiquid loans to the corporate or financial sector. Hence, a rapid
reversal of the inflows could potentially affect asset prices, but is unlikely to have the kind of
real effects, via corporate and banking sector balance sheets, that occurred during the crisis.
In addition, the capital and financial account surplus has averaged less than 1 percent of GDP
in recent years as some banks and corporates have been repaying loans, while the current
account has remained in surplus, with the substantial overall surplus leading to reserves
accumulation. This suggests that even a quite substantial portfolio outflow could be
accommodated without necessitating a drawdown in reserves.
22
The weighted average price-equity (PE) ratio for April 2007 was around 18.2, compared with an average of
21.4 for the pre-crisis period (January 1992–July 1997; Data from CEIC). A fuller assessment of asset price
sustainability would compare PE ratios with forecasts of future earnings, which is beyond the scope of the
current chapter.
30
55. Another concern is that despite the significant reserves accumulation, the level of
reserves is still insufficient to fully deter or provide cover against speculative attacks or
sudden stops.23 For instance, Wyplosz (2007) argues that, while the Asian crisis countries
have done much to reduce vulnerabilities, including by significantly building reserves, the
level of reserves required to defend the currency in all circumstances is prohibitively large,
particularly given the volume of global capital flows and an increase in investors’ risk
appetite (that makes the demand for emerging market assets more elastic with respect to
expected yield differentials). Therefore, traditional benchmarks of reserves adequacy may
paint too complacent a picture.24
56. To illustrate this point, the level of reserves can be compared with the kind of
capital account reversals associated with 60
Figure III.4.Reserves Holdings and Capital Account Reversals
sudden stops and financial crises. Table 50
(In percent of GDP) Malaysia
III.16 shows reserves holdings (as a 40 Cumulative 2 Year Capital Account
percentage of GDP) in the Asian crisis Reversal

Reserves in 2006 Thailand
30
countries (and three other emerging market Korea
comparators) in 1996 and 2006, set against 20 Philippines
Indonesia
the capital account reversals that occurred in 10 1 Year Capital Account
1997–98.25 Clearly, the level of reserves in 0
Reversal
0 10 20 30 40
Indonesia in 1996 was insufficient to cover Capital Account Reversal Distribution (percentiles)
Source: IMF, International Financial Statistics ; and Jeanne and Ranciere, 2006.
the capital account reversal experienced in
1997 and 1998. Moreover, the level of reserves in 2006 remains at around half the level
required to cover a reversal of similar magnitude (as a share of GDP).
23
A sudden stop (defined as a substantial reversal of the capital account), from the basic Balance of Payments
identity, must be covered by a combination of a movement toward surplus in the current account and the
rundown of reserves. To the extent that reserves depletion cannot cover the capital account reversal, then the
current account must move into surplus, generally requiring a significant real exchange rate depreciation as well
as a contraction in domestic demand (this is the ‘transfer problem’ highlighted by Krugman, 1999). Passthrough
to inflation means that the nominal depreciation required for a given real depreciation is significant, while lower
domestic demand implies a substantial recession which impacts on firm solvency. These heightened currency
and solvency risks exacerbate the balance sheet problems highlighted in Section C.
24
Jeanne and Ranciere (2006) calibrate an optimal reserves holding model and find that the optimal level of
reserves is close to that implied by the Greenspan-Guidotti rule. However, their model differs from Wyplosz’s
in assuming exogenous crises (with reserves having a mitigating role on the crisis’s effect on consumption),
whereas Wyplosz’s model is essentially a bank run model with endogenous crises potentially occuring when
reserves are below a threshold. This threshold can be extremely high.
25
The crisis years differ for the non-Asian comparators (see notes accompanying the table).
31
57. Reserves can also be compared against the full spectrum of capital account
reversals (‘sudden stops’) experienced globally. Figure III.4 compares reserves holdings
(as a percentage of GDP, end-2006) in the Asian crisis countries against the percentiles of the
capital account reversals experienced in a wide sample of countries (up to 150, depending on
the year) over 1976–03, taken from Jeanne and Ranciere’s (2006) dataset. The extent of
additional reserves accumulation required to cover the most extreme events would clearly be
large for Indonesia (as for the other countries shown, with the exception of Malaysia). For
instance, Indonesia’s reserves at end-2006 would be insufficient to cover around 4 percent of
the 1-year capital account swings experienced globally between 1976 and 2003, and around
12 percent of the 2-year swings.26 This suggests that some additional reserves accumulation
might be desirable. However, the cost of holding additional reserves (including sterilization
costs and potential negative valuation effects) need to be balanced against the benefits. Other
risk mitigation policies may be less costly, though only effective in the medium term: these
could include policies to promote financial market liquidity (to minimize the effect of sudden
capital outflows on asset prices and the exchange rate) and a heightened emphasis on
financial sector surveillance (to minimize the risk of a sudden stop caused by a collapse in
investor confidence).
Table III.16. Reserves and Capital Account Reversals

(In percent of GDP)
Asian Crisis Countries Other EMEs

Indonesia Korea Malaysia Philippines Thailand Brazil South Africa Turkey
Reserves
1996 8.2 6.4 27.0 12.5 21.0 7.8 0.9 12.1
2006 11.1 26.2 53.1 16.6 30.2 7.9 9.4 15.0
Capital Account Reversal

1st year -6.9 -7.2 -4.9 -8.5 -19.4 -4.7 -3.1 -14.2
2nd year -6.4 -1.4 -1.4 -1.9 -5.1 0.7 1.5 11.9
Combined -20.1 -15.8 -11.1 -18.9 -43.9 -8.7 -4.7 -16.4
Source: IMF, International Financial Statistics; and Jeanne and Ranciere (2006).
Capital Account Reversals: 1997-98 (Asia), 2002-03 (Brazil), 2001-02 (Turkey) and 2000-01 (South Africa)
Capital account reversal defined as the change in the capital account as a percentage of GDP (y/y)
Combined reversal defined as 1st year plus the cumulative 1st and 2nd year (total 2nd year vs. baseline)
G. Conclusions
58. Indonesia has come a long way in overcoming macroeconomic vulnerabilities

since 1997. Monetary and fiscal policies remain cautious, helping to reduce external and
public debt levels and build up foreign exchange reserves. The exchange rate is more
26
The sample of countries includes some very small and open economies which typically experience much
greater capital account swings; hence, a relatively large and closed economy such as Indonesia is probably less
likely to experience a shock of a given high magnitude than the probability implied by the full distribution of
capital account reversals.
32
flexible, increasing the economy’s resilience and reducing the risk of a speculative attack. In
the financial sector, the recapitalization and reorganization of the banking sector, greatly
improved regulation and supervision, and less exposure to foreign exchange risk help to
minimize risks. Broader institutional reforms help to reduce the risk of a repeat of the close
political-corporate links that helped to create financial sector vulnerabilities in the 1990s.
59. Nevertheless, vulnerabilities have not been eliminated. Regional capital markets
are more integrated, presenting opportunities for risk diversification but also increasing the
potential for financial contagion. Recent large capital inflows are presenting challenges to
policymakers. There are risks from a sharp tightening in global financial conditions, as for all
countries, although there is no evidence that Indonesia faces a disproportionate risk (e.g.
because of significant exchange rate misalignment or an asset price bubble). The build-up of
reserve assets in recent years helps to insulate Indonesia against the risk of a sudden stop,
although it should be recognized that these shocks can potentially be extremely large, even
compared with Indonesia’s increasing stock of reserves.
33
REFERENCES
Allen, Mark, Christoph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini, 2002,
“A Balance Sheet Approach to Financial Crisis.” IMF Working Paper WP/02/210.
Washington, DC: International Monetary Fund.
Baig, Taimur and Ilan Goldfajn, 1998. “Financial Market Contagion in the Asian Crisis.”
IMF Working Paper WP/98/155. Washington, DC: International Monetary Fund.
Bank for International Settlements (BIS), 1998, 68th Annual Report. Basle: Bank for
International Settlements.
Berg, Andrew, 1999, “The Asia Crisis: Causes, Policy Responses, and Outcomes.” IMF
Working Paper WP/99/138. Washington, DC: International Monetary Fund.
Dornbusch, Rudiger, 2001, “A Primer on Emerging Market Crises,” NBER Working Paper
8326. Cambridge, Massachusetts: National Bureau of Economic Research.
Finger, J.M. and M. E. Kreinin, 1979, “A Measure of ‘Export Similarity’ and Its Possible
Uses,” The Economic Journal 89, pp. 905–912.
Forbes, Kristin and Roberto Rigobon, 2002, “No Contagion, Only Interdependence:
Measuring Stock Market Comovements.” The Journal of Finance 57 (5) pp. 2223–61.
Goldstein, Morris, 1998, “The Asian Financial Crisis: Causes, Cures and Systemic
Implications,” Policy Analyses in International Economics 55, June. Washington,
DC: Institute for International Economics.
Hill, Hal and Takashi Shiraishi, 2007. “Indonesia After the Asian Crisis.” Asian Economic
Policy Review 2, pp.123–141.
International Monetary Fund, 2007. “Indonesia: Staff Report.” Washington, DC:

International Monetary Fund.
International Monetary Fund, 2006. “Corporate Sector in Indonesia: Financial Performance

and Underlying Vulnerabilities.” In International Monetary Fund, 2006, “Indonesia:
Selected Issues.” (Washington, DC).
International Monetary Fund, 2004. “Assessing Indonesia’s Banking Sector Reforms.” In

International Monetary Fund, 2004, “Indonesia: Selected Issues.” (Washington, DC)
34
Jeanne, Olivier and Romain Ranciere, 2006. “The Optimal Level of International Reserves
for Emerging Market Countries: Formulas and Applications.” IMF Working Paper
WP/06/229. (Washington, DC: International Monetary Fund).
Krugman, Paul, 1999, “Balance Sheets, The Transfer Problem and Financial Crises,”
(mimeo, MIT, January 1999, http://web.mit.edu/krugman/www/FLOOD.pdf).
Nasution, Anwar, 2007. “Comment on ‘Are Banking Systems in East Asia Stronger?’” Asian
Economic Policy Review 2. pp. 96–97.
Pangestu, Mari and Manggi Habir (2002), “The Boom, Bust and Restructuring of Indonesian
Banks,” IMF Working Paper 02/66. (Washington, DC: International Monetary Fund).
Reinhart, Carmen and Kenneth Rogoff, 2004. “The Modern History of Exchange Rate
Arrangements: A Reinterpretation.” Quarterly Journal of Economics 119 (1),
pp. 1–48.
Roubini, Nouriel, 2007. “Asia is Learning the Wrong Lessons from its 1997–98 Financial
Crisis: The Rising Risks of a New and Different Type of Financial Crisis in Asia.”
New York: New York University, Mimeo. First Draft, May 2007.
Turner, Philip, 2007. “Are Banking Systems in East Asia Stronger?” Asian Economic Policy
Review 2, pp. 75–95.
Wyplosz, Charles, 2007. “Is East Asia Safe from Financial Crises?” HEI Working Paper No.
2/2007. Geneva: Graduate Institute of International Studies.
35
IV. BUILDING A FINANCIAL SAFETY NET IN INDONESIA27
The introduction of a financial safety net (FSN) in Indonesia was completed in March 2007
with the phasing-out of the blanket deposit guarantee introduced at the time of the crisis. The
FSN is aimed at preventing financial instability by clarifying responsibilities in the provision
of lender-of-last resort facilities, the administration of the explicit limited deposit protection,
the management of bank resolution processes, and the monitoring of systemic risks. Next
steps include improving information flows, eliminating overlaps, and enhancing legal
certainty.
A. Background
60. The absence of a preventive framework prior to the 1997–98 financial crisis
contributed to its severity. In the decade prior to the crisis, financial liberalization resulted
in easy entry of new participants and inadequate exit provisions for failed institutions. Over
time, governance problems in the corporate and banking sectors became widespread in the
context of poor enforcement of prudential regulations. In handling the crisis, weak
institutions, the absence of a preventive framework, and protracted delays in implementing
measures conspired against generating public trust in the authorities’ plans.
61. Specific problems related to the absence of an FSN during the crisis were the
following:
• Weak prudential regulation and supervision did not allow for a timely
identification of bank problems. Serious institutional and governance shortcomings
hampered the effectiveness of prudential monitoring. Once the extent of delinquent
loans and connected lending became evident, it was found that “state banks had been
used as vehicles for directed lending to noncommercial ventures, and private banks as
vehicles for channeling deposits to the owners.” 28
• Difficulties in distinguishing between illiquid and insolvent banks led to an

indiscriminate use of Lender-of-Last-Resort (LOLR) facilities. Once problems
erupted, Bank Indonesia (BI) provided massive liquidity support without being in the
position to discern between illiquid and insolvent institutions. By mid-1998, the use
of BI’s Lender-of-Last-Resort Facility (BLBI) reached the equivalent of 14 percent of
GDP, mostly extended against personal guarantees (in the absence of usable
collateral), in a process plagued with irregular practices.
27
Prepared by R. Armando Morales (APD). Special thanks to Steven Seelig, who provided guidance and
background information, and to Edo Mahendra and Wiwit Widyastuti (IMF Jakarta Office) for their valuable
research assistance.
28
Enoch, Charles; B. Baldwin; O. Frecaut; and A. Kovanen. Indonesia: Anatomy of a Banking Crisis: Two
Years of Living Dangerously; IMF Working Paper No. 01/52, Washington D.C., 2001.
36
• The absence of a framework for the provision of deposit guarantees contributed

to depositors’ uncertainty. Limited ad-hoc deposit refunds applied to closed banks
failed to inspire confidence.29 By the time a bank-restructuring plan based on a
blanket guarantee was introduced, a large share of deposits had already been moved
out of the domestic banking system.
• Undue delays in making and implementing decisions regarding bank

restructuring led to higher than necessary loss of banks’ asset value. Although a
bank resolution package was announced at the beginning of November 1997,
Indonesia introduced a bank restructuring process only in January 1998, managed by
the Indonesia Bank-Restructuring Agency (IBRA), a combined bank-restructuring
and centralized public asset management agency. That stopped the drain of deposits,
but the costs in terms of fiscal resources reached about 40 percent of GDP. IBRA
itself did not always manage the process in a timely manner.30
• An unclear allocation of responsibilities in the absence of an appropriate legal

framework, led to inconsistent decisions in handling banks’ failure. For example,
the authorities’ reluctance to close banks that later proved insolvent led BI to turn
LOLR outstanding obligations into long-term low-interest subordinated loans. On
banking resolution, the absence of legal liquidation provisions specific to banks
slowed down unnecessarily the recapitalization of problem banks.
62. Following the crisis, the authorities decided to introduce a preventive framework
in the form of an FSN supported by an explicit limited deposit guarantee.31 The
1998 banking law already anticipated the introduction of a deposit guarantee scheme, and
revisions to the central bank law in 2004 facilitated the re-introduction of LOLR capabilities
for BI. The latter had been removed in 1999 following BLBI mismanagement problems. The
intended purpose of the FSN was to establish the roles of different institutions (BI, Ministry
of Finance, Deposit Guarantee Agency) in the monitoring of systemic risks and the handling
of financial problems. With the introduction of the FSN, ad-hoc arrangements are not
necessary, and therefore fewer opportunities for political interference are available. Other
countries in the region also moved towards introducing FSNs, with features consistent with
the specific situation of their financial systems (Box IV).
63. Ten years after the crisis, the main components of a comprehensive financial
safety net are in place. The blanket guarantee used at the time of the financial crisis as a
short-term crisis management tool has been phased out, and the roles of participating
institutions have been established (Figure IV.1):
29
Batunanggar, Sukarela; Financial Safety Nets: Review of Literature and its Practice in Indonesia, in Financial
Stability Review II-2006, Bank Indonesia, Jakarta, 2006.
30
Some delays also occurred because of overall institutional deficiencies rather than IBRA-specific problems.
31
The government’s plan to introduce a financial safety net was incorporated into the 2000 EFF program with
the Fund.
37
• The necessary regulations to make LOLR facilities operational have been introduced.
• A deposit guarantee agency (LPS) is now functioning, and a new deposit guarantee
scheme is in place following the transition period completed in March 2007. A bank
resolution framework was introduced in the LPS law, and is now operational.
• A Financial Stability Forum (FSF), with participation of BI, the Ministry of Finance
(MoF) and the LPS, has been established to coordinate the government’s actions with
regard to systemically important institutions experiencing difficulties.
64. The introduction of the FSN has been accompanied by significant improvements
in banking supervision, in an environment of overall macroeconomic and financial
stability. This is consistent with good practices.32 Critical regulatory measures were adopted
in the aftermath of the crisis, including improved loan-loss provisioning regulations; a
timetable to phase out regulatory forbearance on capital requirements, bringing back capital
adequacy requirements from 4 percent to 8 percent of risk-weighted assets by 2001; and
narrowing legal lending limits. The 1999 central bank law granted BI additional regulatory
and enforcement authority, which allowed BI to introduce the gradual adoption of risk-based
supervision; measures to improve banks’ transparency; enhanced on-site supervisory
capacities; and fit-and-proper tests for controlling shareholders and bank management. In
recent years, the supervisory framework has been further improved by introducing good
corporate governance regulations; and exercising surveillance more closely through teams of
bank supervisors.
65. This paper aims at assessing the suitability of the new framework to respond to
possible bank problems. In this regard, the paper discusses the different components of the
FSN, especially design issues and potential costs, and evaluates the main sources of risks and
corresponding challenges, taking into account international experience.
32
See Garcia, Gillian G. H.; Deposit Insurance: Actual and Good Practices, IMF Occasional Paper No. 197,
Washington, DC, 2000.
38
BOX IV.1. FINANCIAL SAFETY NET: INTERNATIONAL EXPERIENCE AND REGIONAL

DEVELOPMENTS FOLLOWING THE ASIAN FINANCIAL CRISIS
Financial safety nets in different countries have evolved in line with specific financial
and institutional circumstances. In the US, the disastrous savings-and-loans experience in
the 1980s motivated stricter FDIC regulations and provisions for Federal Reserve emergency
lending. In the EU, major bank failures (BCCI in 1991 and Barings in 1995) led to agreement
on a basic framework to resolve financial institutions and their branches as a single entity
(2001 Directive on the Reorganization and Winding-Up of Credit Institutions). In Japan, the
banking resolution framework has been revised several times to incorporate lessons from the
prolonged experience in dealing with troubled banks. In Australia, a highly concentrated
banking system has allowed authorities to handle bank failures case-by-case, but the
government has plans to introduce formal procedures for handling bank distress.
The Asian crisis influenced decisions regarding the FSN in several countries in the region:
• Some pre-existing FSN arrangements were used at the time of the crisis. Korea
used extensively the emergency liquidity assistance facility. The Philippines, where
the impact of the banking crisis was relatively mild, basically maintained the deposit
guarantee scheme instituted in 1963.
• In countries where the crisis hit more strongly, transitional arrangements were
necessary. Korea replaced its then recently introduced partial deposit insurance
scheme with a blanket deposit protection system, to reintroduce the original scheme
again in 2001 with broader prudential monitoring capabilities for the Korean Deposit
Insurance Corporation. The Thailand Financial Institutions Development Fund
administered a temporary general guarantee to depositors between October 1997 and
December 2004, when a new deposit insurance agency was created.
• Specific country circumstances explain different priorities among countries in

the region. In the Philippines, the authorities focused on handling rising
nonperforming loans by using incentives introduced in the 2002 Special Purpose
Vehicles Act. The Hong Kong Monetary Authority formalized in 1999 a LOLR
facility funded by the Exchange Fund under their quasi-currency board arrangements.
• Most countries in the region have introduced deposit protection schemes and
systemic monitoring arrangements. Deposit insurance institutions have been
established in Hong Kong (2004), Singapore (2005), and Malaysia (2005).
Institutional arrangements to monitor systemic risk have been implemented in Hong
Kong (Financial Stability Committee and the Council of Financial Regulators), and in
Singapore the Monetary Authority of Singapore has in place a crisis management
framework covering a range of possible contingencies.
39
Figure IV.1. Indonesia: Financial Safety Net
B. Components of the Financial Safety Net
Liquidity assistance
66. The 2004 central bank law reinstated standard LOLR capabilities to BI. The
Law states that BI can extend credit via an emergency loan facility (FPD), funded by the
government, to solvent banks with liquidity problems and of systemic importance. If
necessary, the government can issue government securities to finance FPD funding following
standard budget procedures. A Joint Coordinating Committee decides on the systemic
importance of banks with MoF making the formal decision.33
67. The LOLR capabilities in Bank Indonesia is a key element of the financial safety
net. Banks entitled to draw on this facility must meet a 5 percent minimum capital adequacy
ratio and pledge liquid assets as collateral, accompanied by personal or corporate guarantee
from their controlling shareholders. All available bank assets can be used as collateral. They
can be supplemented by other assets, including those belonging to the controlling
33
The precedent for this arrangement is the assumption of BLBI obligations by the government in exchange for
recapitalization bonds. Other arrangements under which the Minister of Finance participates in LOLR decisions
are in place in Japan, where the Minister of Finance may ask the central bank to provide loans to prevent
financial turmoil, and in Jordan, where the cabinet approves the use of emergency credit facilities by the central
bank.
40
shareholder, and/or by registered shares from the controlling shareholder in the bank. The
facility is available for 90 days, and can be extended once for another 90-day period
(Figure IV.2).
68. The LOLR facility in Indonesia is available only to systemically-important

institutions. BI has also a Short-Term Liquidity Facility (FPJP) available to all banks with
sufficient liquid and high-value collateral (government and central bank securities) to finance
payment system obligations. This credit can be renewed for up to 90 days, although in
practice, it has been rarely used and never for more than two days.34
Figure IV.2. Indonesia: Lender of Last Resort
Deposit protection
69. Depositors’ confidence remained unaffected throughout the gradual

introduction of a limited deposit guarantee. After the creation of LPS in 2004, the blanket
deposit guarantee was phased out in four stages between March 2006 and March 2007.35 The
new limited deposit guarantee coverage was set at Rp 100 million per depositor per bank
(about US$11,000). This amount provides full coverage to about 98 percent of all depositors
and to 38 percent of deposits, based on information as of March 2007. Participant banks pay
premiums of 0.1 percent of total deposits twice a year.
34
A problem may arise if the provision of LOLR assistance delays the closure of institutions, thereby increasing
the resolution costs for the deposit guarantee agency. The US introduced legislation in 1991 to limit the ability
of the Federal Reserve to lend to insolvent banks even when collateral was available, in light of excessive use of
these facilities in previous years.
35
Coverage was reduced to Rp. 5 billion in March 2006, Rp. 1 billion in September 2006, and Rp. 100 million
in March 2007.
41
70. All financial institutions supervised by BI are members of the Deposit Guarantee
System. Member institutions comprise 130 commercial banks and 1,880 local development
banks (BPR). Currently, LPS resources invested in securities (equivalent to 0.54 percent of
total deposits) would be sufficient to finance deposit refunds for 30 percent of small domestic
private banks or 45 percent of all rural banks (Figure IV.3). The new framework for deposit
protection has already been successfully tested following the failure of six rural banks in the
last two years.
71. LPS has a broad mandate. In addition to providing a limited guarantee to bank
deposits, it is responsible for the resolution and management of failing banks.36 To avoid
adverse-selection problems, the system is compulsory for all commercial and rural banks,
and is partly funded with government resources, in line with most newly established deposit
guarantee schemes.37 LPS has operational independence and is accountable to the President
of the Republic. The guaranteed deposit limit may be raised with Parliament’s approval in
the event of acceleration of inflation, decline of coverage to below 90 percent of depositors,
or substantial bank deposit withdrawals (Figure IV.4).
72. LPS financial arrangements are generally conservative. Assets can only be
invested in securities issued or guaranteed by the government or BI. As in most countries,
foreign banks also contribute to the fund in the understanding that they also benefit from
enhanced confidence. Reserves have an explicit target of 2.5 percent of total deposits, with
the idea of building reserves only up to the level of expected contingencies. Unlike most
countries, contribution is based on total deposits, ensuring simplicity in collecting
premiums.38 Simplicity and maximum premium collection potential are important
considerations in countries with high coverage per depositor like Indonesia. Like most other
countries, Indonesia does not have a risk-based premium system in place (where banks pay
premium based on risk assessments by third parties) (Figure IV.5). However, the Deposit
Guarantee Law opens the possibility to eventually move to a risk-based premium system.
36
Asian and Western Hemisphere countries favor comprehensive deposit guarantee schemes, unlike European
countries where central banks or regulatory bodies other than the deposit insurance agency have had clearly
defined banking resolution responsibilities for a long time (Garcia, 2000).
37
Initial capital participation of the government amounts to Rp 4 trillion (about US$ 400 million).
38
Premiums are applied only to covered deposits in most countries. However, some countries are considering
shifting the application of premiums to total deposits for simplicity.
42
Figure IV.3. Indonesia: Features of Deposit Coverage Under Deposit Insurance Scheme,
December 2006
40 600
Number of Banks 1/ Deposits
(In trillions Rupiah)
35
500
30
400
25
20 300
15 200
10
100
5
0
0
Private nonforex
Private forex
BPR
BPD
State
Joint Venture
branches
Foreign
Private forex
nonforex
BPD
State
Joint Venture
branches
Foreign
Private
1/ Deposit banks only, not includes the 1880 rural

banks.
120 60
Average Deposit per Bank 1/ LPS Investments as a Share of Total Deposits in Each
(In trillions Rupiah) Group
100 50 (in percent)
96.1
80 45.0
40
60
30
29.1
40
20
19.8
20
15.0 10
5.0 8.4 0.7 2.1
0 5.5 7.7 1.5 1.4 0.5
Private forex
Private nonforex
BPD
State
Joint Venture
branches
0
Foreign
Private forex
Private nonforex
BPR
BPD
State
Joint Venture
Total
branches
Foreign
1/ The average deposit for the rural banks is 8.4

billions Rupiah.
Source: BI and Fund staff calculations.

43
Figure IV.4. Indonesia: Deposit Guarantee Scheme
73. The Deposit Guarantee Law clearly states when claims can be declared ineligible
by LPS. This can occur if claims cannot be corroborated in bank records, as well as if
depositors were responsible for the insolvency situation of the banks or are parties that
benefited from bad prudential practices. In applying the latter provision, LPS announces
every month a ceiling deposit interest rate that banks cannot exceed in order to ensure
eligibility for deposit protection.
44
Figure IV.5. Selected Economies: Features of Deposit Insurance Schemes, 2006
45 30
Membership - Branches of Foreign Banks Funding - Fund Target
40
(number of countries) 25 (number of countries)
35
30 20
25 Indonesia: YES
Indonesia: YES 15
20 YES YES
15 NO 10 NO
10
5
5
0 0
pe
pe
a
ia
st
ia
st
re
re
r ic
r ic
As
Ea
As
Ea
e
e
ro
ro
ph
ph
Af
Af
Eu
Eu
e
e
is
is
dl
dl
em
em
id
id
M
M
H
H
rn
rn
te
te
es
es
W
W
40 30
Premium - Based on Total Deposits Premium - Risk Adjusted
35 (number of countries) 25 (number of countries)
30
20 Indonesia: NO
25
Indonesia: YES
20 15 YES
YES NO
15
10
NO
10
5
5
0 0
pe
pe
a
ia
ia
st
st
re
re
r ic
r ic
As
As
Ea
Ea
e
ro
ro
ph
ph
Af
Af
Eu
Eu
e
e
is
is
dl
dl
em
em
id
id
M
M
H
H
rn
rn
te
te
es
es
W
40 40
Coverage - Deposit ME Coverage - Ceiling to 2003 per-Capita GDP
35 (number of countries) 35 (number of countries)
30 Indonesia: YES 30
25 Indonesia: 10.61
25
20 YES 20 Ratio Higher than 3
15 NO 15 Ratio Lower than 3
10 10
5 5
0 0
pe
st
a
ia
re
pe
a
ia
st
re
r ic
As
Ea
he
r ic
ro
As
Ea
he
ro
Af
Eu
Af
p
Eu
p
is
e
dl
is
dl
em
id
em
id
M
H
M
H
rn
rn
te
te
es
es
W
Source: IMF.
45
Bank resolution
74. In case of solvency problems, BI’s Banking Supervision Department (BI-BS)

hands over the resolution of the bank to LPS. A coordinating committee (whose members
are currently the Ministry of Finance, Bank Indonesia and LPS) will determine if a failed
bank is of systemic importance.39 Liquidation is not an option in the case of failing banks of
systemic importance, but shareholders can only participate in the recapitalization of assisted
banks if they inject at least 20 percent of additional capital requirements. Alternatively, LPS
will take over all the corresponding rights and powers. In the case of non-systemically
important banks, LPS will choose between recapitalization or liquidation based on an
assessment of the costs of bank assistance versus the costs of liquidation (lower cost
approach). LPS must dispose of banks’ shares within a period of 2 years for banks of no
systemic importance and 3 years for banks of systemic importance, renewable for no more
than 2 additional years.
75. LPS legal capabilities are generally sufficient to carry out banking resolution
duties. LPS is empowered to: take over and exercise all rights and powers of shareholders;
possess and manage assets and liabilities of the failing bank; review, annul, terminate and/or
alter any contracts between the failed bank and third parties; and, sell and/or transfer failing
bank assets and liabilities without debtor or creditor consent.
76. Information sharing agreements between LPS and BI are not yet firmly
established. Information arrangements need to be put in place to properly monitor the risks
that problem banks pose to the deposit guarantee fund. The lack of information sharing
arrangements may potentially delay key decisions at the time of bank resolution, making the
process unduly costly. Currently, BI-BS must notify the LPS about problem banks under
special supervision. However, given that LPS regulations stipulate that a decision on the
modality of banking resolution should be made in one day, it is critical that relevant
information is made available early in the process (Figure IV.6).
77. In the case of liquidation, LPS will repay the guaranteed claim to depositors and
dissolve the bank. Following a public announcement of a bank’s liquidation, LPS will
appoint a liquidation team, which may include one member of the board of directors,
commissioners or shareholders. The liquidation team has ample powers to act on behalf of
the bank under liquidation in every aspect pertaining to the settlement of the rights and
liabilities of the bank. This includes requesting from a commercial court the cancellation of
transactions that had an impact on the reduction of assets and increasing liabilities within one
year prior to the revocation of the bank’s license. The process of liquidation must be
completed within 2 years from the establishment of the liquidation team, to be extended no
more than twice for a maximum of one year each time.
39
This decision is independent of the one made about the use of LOLR facilities for systemically important
banks.
46
Figure IV.6. Indonesia: Banking Resolution Framework
Financial stability forum
78. The Financial System Stability Forum (FSF) is a vehicle for cooperation,
coordination, and information exchange, with the objective of monitoring and
preserving financial system stability. Since its main purpose is to facilitate coordination
between the MoF, Bank Indonesia and LPS on monitoring systemic risks, it is not expected
to constitute a separate and distinct entity.40 However, provisions in the MoU signed in
December 2005 establish additional roles to the FSF such as taking actions to ensure
consistency in financial acts and regulations, developing an early warning system to detect
potentially systemic problems, and interacting with managers of individual financial
institutions to discuss systematically important developments (Figure IV.7).
40
The Australian Council of Financial Regulators operates as an informal body where members share
information and views, discuss regulatory reforms or issues where responsibilities overlap and, if the need
arises, co-ordinate responses to potential threats to financial stability. The Norwegian Contingency Committee
for Financial Infrastructure is chaired by the central bank, which provides a secretariat, and its main
responsibility is to coordinate measures for preventing and resolving crisis situations that may lead to major
disruptions in financial infrastructure.
47
Figure IV.7. Indonesia: Financial Stability Forum
C. Conclusions and Macroeconomic Stability Considerations
79. The FSN in Indonesia provides a framework to address the kind of problems
that emerged at the time of the crisis. In addition, significant improvements in banking
regulation and supervision and progress in disclosure by firms should help identify the nature
of bank problems at an early stage. Features of the new financial safety net that make it
capable of timely addressing bank problems are the following:
• A framework to decide on the solvency and on the systemic importance of a

bank in distress has been formalized. This will help prevent the abuse of
regulations to unduly support failing banks. It will also help minimize uncertainty
about alternative courses of action, which was a major problem at the time of the
crisis. Accountability for determining systemic importance appropriately falls on the
Minister of Finance, BI’s Governor, and LPS’s Chairman. The definition of systemic
importance within a “constructive ambiguity” approach remains appropriately open,
to avoid moral hazard behavior by banks falling within a particular definition. Current
arrangements leave no room for discretion in determining the use of LOLR to attend
emergency liquidity needs of banks deemed as solvent.
• Clearly established procedures, clear allocation of responsibilities and legal

certainty about key roles facilitates the adoption of timely decisions. This applies
to the provision of emergency liquidity, banking resolution processes, deposit
refunds, and liquidation. Changes in the central bank law and the enactment of the
48
Deposit Guarantee Law provide legal support to these arrangements. In turn, the
favorable environment for timely decisions would be conducive to maintaining
potential costs at a minimum.
• The establishment of new specialized institutions should help focusing on

systemic risks on an ongoing basis. The LPS, in charge of administering the deposit
guarantee, will remain vigilant about potential use of deposit protection. Building up
LPS’s credibility will help enhance the perception of safety by depositors,
contributing to minimize the probability of deposit runs. The FSF, in charge of
assessing systemic risks, will help alert about emerging risks, favoring the activation
of self-correcting adjustments by regulators and market players.
80. The FSN would be further strengthened by continuous improvement in legal and
judicial systems, market-based discipline, accounting standards, and enhanced
disclosure.41 While progress on addressing these structural issues can only be gradual, a
complementary effort to minimize potential moral hazard costs seems appropriate. It is
widely accepted that the benefits of FSNs come at the cost of undermining market discipline
to some extent, which is made worse when many financial institutions are regarded as too
important to fail.42 In this regard, the following features of the FSN could impose high moral
hazard costs: (i) higher than average deposit coverage; (ii) the significant presence of state-
owned banks in the system; (iii) the possibility to use payment liquidity facilities for up to
90 days; and (iv) the potential conflicts of interest if a member of the board of directors,
commissioners or shareholders participates in liquidation teams. Moral hazard costs could be
minimized by continuously improving the prudential framework, introducing stricter
governance requirements in state-owned banks, and limiting the use of legal provisions with
potential moral hazard implications.
81. The authorities may consider reassessing periodically elements of the FSN to
further improve the framework, in particular in the following areas:
• The FSN should be supported by full legal certainty to ensure effectiveness. The
government plans to submit an FSN law to parliament to reinforce legal certainty for
some of the main regulations already in place. The new law could usefully assess
consistency in the identification of a systemic problem, which currently takes place in
two separate moments.43 Also, provisions in the Deposit Guarantee Law allowing for
41
See Mishkin, Frederic; Financial Policies and the Prevention of Financial Crises in Emerging Market
Countries. NBER Working Paper No. 8087, Boston, 2001.
42
Schinasi, Garry; B. Drees and W. Lee, Managing Global Finance and Risk, Finance and Development,
Volume 36, Number 4, Washington D.C., December 1999.
43
There may be a legal gap in the unlikely but not impossible case that different decisions are made regarding
the systemic importance of the same institution at the time of the provision of LOLR financing and at the time
of the decision on what resolution approach is chosen.
49
coverage adjustments at times of financial turmoil may lead to the perception that a
“quasi-”blanket guarantee is still in place.44
• Market-based mechanisms should take preference over administrative

procedures. In particular, the deposit guarantee ceiling rate does not seem to play the
role of discouraging bad prudential practices by preventing weak banks from bidding
for deposits to finance liquidity problems, since these institutions still pay a rate that
is significantly higher than market rates at times. A mechanism used in other
countries, and more in line with the intention of the LPS law, would entail relating the
deposit guarantee rate to an average market rate plus a reasonable margin.45 Also,
risk-based premiums could be introduced when BI has a reliable and objective way to
assess banks’ differential risks, for example based on external ratings. On banking
resolution, consideration could eventually be given to allow the use of other market-
friendly alternatives tried successfully in other countries (bridge banks, purchase and
assumption), not contemplated in the current Deposit Guarantee Law.
• The risk of higher resolution costs arising from undue delays in decisions on
handling bank failures should be minimized. Appropriate information exchange
between regulators and LPS would help better informed decisions. An MoU should
be signed in line with the LPS Law, which establishes that the LPS must obtain
customer’s deposit data, as well as bank soundness reports and financial statements
and banks’ examination reports to the extent that banks’ secrecy is preserved.
• The monitoring of systemic vulnerabilities should be carried out with emphasis

on inter-institutional coordination. Regarding the Financial Stability Forum, it
seems advisable to keep its infrastructure to a minimum, in line with international
experiences. The FSF should focus on facilitating coordination, rather than on
functions that potentially overlap with other regulators, such as interacting directly
with financial institutions.
44
A blanket guarantee could still be used, if deposit runs are not stopped by the use of emergency liquidity
facilities (See Lindgren et al, Financial Sector Crisis and Restructuring: Lessons from Asia, IMF Occasional
Paper No. 188, Washington D.C., 1999).
45
In fact, in Indonesia, the ceiling was set at a fixed margin above the average deposit rate for the largest banks
between 1998 and 1999. Similar arrangements are in place in Argentina, Ecuador and Thailand. Other countries
use narrower approaches: Bulgaria, Germany and Portugal regard as ineligible only individual deposits
receiving preferential interest rates.
50
V. POST CRISIS CREDIT EXPANSION IN INDONESIA46
A. Introduction
82. Credit growth in Indonesia has not been as strong as might be expected given
the strength of its recovery since the crisis. This is not surprising; countries that have
experienced a banking crisis do not experience contemporaneous loan growth with the return
to positive GDP growth.47 Nevertheless, the level of credit to GDP usually returns to pre-
crisis levels after a few years. In the case of Indonesia, the level of private sector lending to
GDP continues to be significantly below pre-crisis levels and is very low relative to other
countries in the region, despite lending having increased by 80 percent during the past three
years.
83. The authorities have expressed concern that the banking system is not
adequately performing its financial intermediation role and contributing to economic
growth. In particular, they have identified the need for funding of infrastructure projects and
small-and medium- sized businesses. There is also concern that unless the banking sector
ramps up the rate of growth of lending the authorities will not achieve their economic growth
targets. Bank Indonesia (BI) has for the past several years announced loan growth targets for
the banking sector. During 2004 and 2005, lending grew at an annual rate of about
20 percent. However, loan growth slowed in 2006 (to a rate lower than the BI target rate) in
response to an increase in interest rates and in energy and food price increases.
84. The authorities have undertaken several policy initiatives to stimulate lending.
Beginning in late 2006, in an effort to spur additional lending, BI announced a series of
relaxations in prudential regulations, including a reduction of capital requirements by
lowering risk weights, as well as a relaxation of provisioning and loan classification rules,
especially for borrowers who had previously defaulted on loans. In addition, the government
has established growth performance benchmarks for state banks and some elements of
government have put pressure on them to make infrastructure loans and to fund the
construction of toll roads.
85. The low credit flows reflect both supply and demand factors. The actions taken by
the authorities are an attempt to influence the supply of credit. However, most independent
analysts believe that bank lending in Indonesia is demand constrained rather than rationed.
This view is supported by the empirical analysis presented in this paper. However, with the
exception of limited corporate bond issuance, there is an absence of long-term lending in
Indonesia, and likely unmet demand for such credit. In the absence of data, this is, however,
46
Prepared by Inutu Lukonga, Elina Ribakova, and Steven Seelig.
47
In addition to the countries affected by the Asian crisis, Sweden, Russia, Uruguay, and others have seen
positive loan growth with a lag after GDP growth becomes positive. The lags have typically been between
18 months and three years.
51
difficult to measure. This paper examines the structural and economic factors that influence
the supply and demand for credit. Two sets of empirical analysis are presented to examine
the importance of these factors and to test whether lending is supply or demand constrained
in Indonesia. It also examines the implications of dramatically increasing loan growth and
presents some policy alternatives to stimulate the extension of long-term financing.
B. Credit Growth in Indonesia
Aggregate Trends
86. Private sector credit in Indonesia, particularly to businesses, has recovered

slowly in the aftermath of the Asian crisis. Nevertheless, nominal growth in private sector
credit averaged 20 percent over the period 2000–2005 and then decelerated to 15 percent in
2006. In real terms, credit growth averaged 13 percent and 0.5 percent respectively. Within
these broad trends, lending to businesses has grown slowly at a nominal rate of 13 percent
compared with 33 percent for consumer lending.
87. Growth in private sector credit has decoupled from the trends in GDP and
deposits as a result of the crisis. Prior to the crisis, the credit cycle tracked the economic
cycle very closely and also trended with deposit growth. Subsequently, however, these trends
diverged as banks replaced their troubled loans with illiquid recapitalization bonds and in
more recent times have allocated excess liquidity to SBIs (certificates issued by Bank
Indonesia (BI)). However, the flow of deposits into the banking sector continued unabated
while credit to the private sector declined significantly in the aftermath of the crisis and has
recovered slowly thereafter.48 In part, this resulted from the initial illiquidity of the
recapitalization bonds.49
88. Beginning in August 2005, the growth in private sector credit decelerated. The
slow down came on the heels of an acceleration in inflation and the subsequent hike in
interest rates, which caused domestic demand to slow. The decline was broad based across
sectors, borrowers and banks, although there were some differences in the magnitude.
Consumer lending appeared to respond more to the rise in interest rates than did business
lending, and the decline in borrowing was more pronounced for the agriculture and
manufacturing sectors. Nevertheless, the various categories of banks reduced loan growth by
similar magnitudes.
89. Intermediation ratios have remained low and have shown little recovery since
the crisis. The credit to GDP ratio increased from 20 percent in 2000 to 26 percent in 2005
before declining slightly in 2006. The intermediation ratios also remain well below some of
48
The sustained flow of deposits in part reflected confidence in the system engendered by the blanket guarantee
on deposits and the subsequent introduction of a limited deposit insurance scheme.
49
Recently these bonds have become more liquid as international investors have been willing to purchase them.
52
Indonesia’s regional peers. Malaysia, Thailand, and Korea exhibit credit/GDP ratios that are
above 90 percent. The loan-to-deposit ratios for Indonesia are also lower than those of the
other countries, possibly reflecting the relatively more inflationary environment and the
higher real lending rates that borrowers face (Figure V.1).
Policy Response
90. In 2004 the authorities began to use moral suasion to encourage loan growth and
followed with relaxation of prudential standards. BI announced growth projections that it
thought were consistent with the government’s growth targets, though these were in no way
obligatory. In 2005, BI introduced a tightening of certain prudential regulations relating to
loan classification and provisioning that were consistent with international standards.
However, it introduced a structure of reserve requirement penalties that progressively
penalized banks with low loan-to-deposit ratios. These surcharges ranged from 1 percent for
banks with loan-to-deposit ratios between 75–89 percent to a 5 percent penalty for banks
with ratios below 40 percent. Beginning in late 2006 and early 2007. BI began to relax
somewhat its prudential standards relating to capital, provisioning and loan classification (see
Box V). State banks have been put under pressure by some elements of government to grow
lending and to finance infrastructure projects, despite a lack of clarity as to the real maturity
of the loans and the available collateral.
91. Staff analysis illustrates, however, that if banks were to reduce liquid assets and
increase loans to 75 percent of assets, the system would be more vulnerable to an
economic downturn. Indeed, an economic downturn that resulted in one third of the loans in
each classification category being downgraded would result in 7 of the 15 largest banks’
capital falling below the 8 percent minimum capital requirement and an additional 4 banks’
capital adequacy ratio (CAR) falling to below 10 percent.
92. Official attempts to increase credit, as a means to stimulate growth, can have
adverse consequences. In response to official support the Korean credit card companies,
some of which were subsidiaries of banks, dramatically increased the number of credit cards
outstanding to over 100 million (approximately 4 cards for every Korean adult).50 This was
accomplished through a significant relaxation in underwriting standards and consumers were
encouraged to use the cards to increase consumption. The end result was that by
November 2003, 34.2 percent of credit card receivables had become nonperforming. As a
result, in 2004 the Korean Development Bank had to acquire credit card companies from
commercial firms, and parent banks had to merge their credit card subsidiaries into the parent
so that loans could be restructured at a loss.
50
IMF. “Republic of Korea—Staff Report for the 2003 Article IV Consultation,” Washington: February 2,
2004.
53
Figure V.1. Indonesia: Credit Relative to Other Asian Countires, 1990 - 2006
(In percent).
180
PSC to GDP Ratios, 1990-2006
Indonesia Malaysia
160 Thailand Philippines
Korea
140
120
100
80
60
40
20
0
1990 1992 1994 1996 1998 2000 2002 2004 2006
180
Credit to Deposit Ratio
160 Indonesia Malaysia
Thailand Philippines
140 Korea
120
100
80
60
40
20
0
1990 1992 1994 1996 1998 2000 2002 2004
54
BOX V.1. RECENT CHANGES IN PRUDENTIAL REGULATIONS
To facilitate bank lending to the private sector, BI has over the last 15 months progressively relaxed a number of the prudential
regulations. The initial measures, the changes that were introduced and the potential impact of these changes are discussed below.
Initial measures
In July 2005, BI issued regulations to strengthen asset classification including: (i) introducing a uniform loan classification
standard that requires that if a borrower misses a payment with one bank, other creditors must reclassify the loans at the same lower
level; (ii) setting out the definition of, and the limits on, large exposures to both related (10 percent) and non-related (25 percent)
parties; (iii) requiring banks to consider off balance sheet items in terms of asset classification; (iv) discontinuing implicit
forbearance granted for restructured loans and setting out clear and specific criteria for classifying restructured assets; and (v)
requiring BI classification of credit to prevail if there is a difference of opinion between the bank and the supervisors;
Prudential measures were also introduced to curb reckless lending to consumers. In November 2005, a ruling was made that
requires banks to ensure that cardholders pay a minimum monthly payment of ten percent of outstanding debt. Effective
December 28, 2005, and in reaction to the growing consumer credit card debt and default, BI issued a ruling requiring a minimum
salary of three times the local minimum wage to qualify for a credit card and for banks which issue the cards to limit the line of
credit to twice a card holders monthly salary.
The Changes
In January 2006, BI modified the uniform loan classification standards so as to apply only to the 50 borrowers whose loans
are the largest exposures of a bank, or to loans of Rp 25 billion (US$2.7 million) or greater. BI also indicated plans to lower this
ceiling to Rp 10 billion (US$1.1 million) in the six months, and Rp 5 billion (US$530,000) in 12 months, but stated that it may
delay implementation of the standards for loans of Rp 500 million (US$53,000) or greater until mid-2007. Concurrently, the credit
risk weight for residential mortgage loans was reduced from 50 percent to 40 percent, while the credit risk weight for small business
loans was reduced from 100 percent to 85 percent. In October 2006, BI announced easing of related lending rules
In April 2007, BI relaxed regulations restricting lending to defaulting borrowers. Amendments were made to the asset
classification and provisioning rules, including: (i) relaxing the criteria used to identify problem loans so as to allow qualifying
banks to classify loans of a certain threshold using backward looking criteria that rely solely on past-due or delinquency status; (ii)
liberalizing the uniform classification rules (UCLL) so as to provide circumstances under which the rule does not apply. Under the
revised ULCC, a bank is now allowed to extend loans to a defaulting borrower if the funds are to be used to fund different projects
and there is a clear separation of cash flows between projects; (iii) expanding the use of eligible collateral for purposes of
determining loan loss provisioning to include machinery and warehouse; and (iv) relaxing the criteria used to classify a placement
made to a rural bank, as part of the government’s credit linkage program.
Assessment
The measures announced in 2005 had the potential to encourage prudent lending by banks. Technically, the regulations had
potential to increase loans that are classified as non-performing and therefore also provisioned by banks. Moreover, they put
pressure on borrowers who wished to increase borrowing to settle their outstanding nonperforming obligations. These changes were
consistent with international best practices in that they required banks to adequately assess and provision for credit risk.
The reversals on the other hand entail a number of general and specific risks. The policy reversals could undermine BI policy
credibility. The backward looking criteria could delay recognition of NPLs and the associated provisions. It is also not clear as to
how the relaxation of backward looking criteria will lead to increased lending since it deals primarily with the process used to
determine when a loan becomes a problem rather than address loan origination and approval standards. Similarly, the relaxation of
the risk weighting for mortgages presents challenges given the problems in Indonesia’s legal-foreclosure framework and the lack of
reliable historical loss data to support the lower risk weights. Finally, the expansion of the use of eligible collateral to include
higher risk and relatively illiquid forms of collateral will require maintenance of reliable collateral appraisal programs and, in the
absence of such review systems, entails an increase in the riskiness of associated lending without necessary provisions. However, it
should be noted that those private banks are unlikely to deviate from international practice and thus the changes will have little
impact on their lending. The impact on state owned banks is less clear.
____________________________
Sources: Bank of Indonesia and IMF staff.
55
C. Factors Impacting Credit Growth
93. For Indonesia, both demand and supply factors appear to have affected credit
growth.
• On the supply side, banks are liquid and the lending capacity has been
increasing. However, a number of factors constrain banks ability or willingness to
lend. Prominent among the factors are the credit risk of the corporates, the
unfavorable legal and judiciary framework for enforcing creditor rights, and
weaknesses in the infrastructure for assessing credit risk. The strengthening of
prudential regulations after the crisis, while strengthening the resiliency of the
system, may have also dampened lending relative to its pre-crisis levels.
• On the demand side, economic activity has been on the upswing. However, a
number of factors appear to be dampening demand, including high lending rates, high
inflation rates, increasing unemployment, and the trend by corporates to deleverage.
94. This section empirically analyzes the relative importance of the various factors
on the supply and demand for credit in Indonesia. The analysis applies a standard supply
and demand model for credit and draws on the work of Louis Catâo (1997). The model and
empirical specifications can be found in Appendix I.
95. The supply equations performed well both in terms of economic theory and
statistics. All variables have the expected sign. Specifically, increases in the supply of bank
credit to the private sector in Indonesia can be explained by the increase in bank liquidity as
reflected in lending capacity and the positive spread on loans. The negative sign on the NPL
variable suggests that credit risk has been a major influence on banks lending decisions and
that banks have curtailed credit supply in the face of high nonperforming loans (NPLs).
96. The demand for credit is

a bit more difficult to model. Indonesia: Re se rve Requirements and Exce ss Rese rves
Most of the variables have the 120,000
expected sign. Demand is clearly 100,000
related to macroeconomic 80,000
conditions and inversely to

Rp bn
60,000
interest rates charged on loans. 40,000
The excess debt variable yielded a 20,000

0
positive sign contrary to
-20,000
expectations. However, since
private sector indebtedness has
0
6
-9
-9
-9
-9
-9
-0
-0
-0
-0
n
n
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
been declining, this result Rp reserve requirements Rp excess reserves

indicates that borrowers reduced FX reserve requiement FX excess reserves
56
their demand for credit as their indebtedness declined (effectively, they deleveraged).
Supply factors
97. Indonesian banks have substantial lending capacity. Although, after

2004, statutory reserve requirements were increased rapidly and progressively, banks’ excess
reserves are substantial and have been increasing.51 The loan to deposit ratio is still low at
65 percent and lower than ratios reported by the other countries in the region. The
restructuring has also led to improved capitalization (20 percent CAR at end-2006) while
NPLs have trended down. Both the short and long term specifications find that banks’
lending capacity is a significant factor in determining the supply of credit.
98. Until recently banks were relatively constrained in their ability to divest recap
bonds. The original bonds issued by the government were fixed rate and illiquid. Several
years ago, a significant portion were converted to floating rate, for which there still is only a
limited market. However, during the past two years foreign portfolio investors have become
willing to acquire the fixed rate bonds.
99. The balance sheet structure of the banks could limit banks ability to finance long
term assets. Similar to many countries in the region, Indonesian banks obtain most of their
funding from short-term deposits. As of end December 2006, more than 90 percent of bank
deposits were less than one month in maturity. Prudent asset-liability management would
therefore call for banks to offer short-term, floating-rate loans. In addition, on the asset side,
recapitalization bonds and other public securities still account for significant shares
(18 percent) and these reduce the bank credit available for private investment while at the
same time resulting in seemingly high capital adequacy ratios.52
100. Corporate profitability and leverage has improved but not enough, thus credit
risk remains high. Data compiled by Moody’s KMV indicates that Indonesian corporate
groups have a higher default probability than corporate groups in Korea, Thailand, and
Malaysia. Indonesian corporates have restructured their financial statements through
agreements with creditors more slowly than those in neighboring countries with the result
that nonperforming loans to these firms are still high. The empirical analysis found that NPLs
are a negative factor influencing the supply of credit in Indonesia. Moreover, reflecting
51
Deposit accounts in foreign exchange are subject to a 3 percent reserve requirement while accounts in rupiah
are subject to a daily reserve requirement in the range of 5 percent to 8 percent, depending on the total amount
of deposits. Effective September 8, 2005, reserve requirements were raised by an additional 1 percent to
5 percent based on the loan to deposit ratio.
52
Given that government securities are zero risk weighted, the capital adequacy ratios of Indonesian banks are
higher than if the banks held loans that are risk weighted.
57
concerns about credit risk, foreign investors have preferred to invest in public sector
securities rather than corporate bonds. Uncertainty about the performance of issuers has also
been a major factor in the sluggish growth of the corporate bond market while signals of
higher default risk have been amplified by the failure of some corporations to meet their
bond obligations.
101. The credit risk is accentuated by weaknesses in the legal and judicial systems. In
the aftermath of the Asian crisis, the authorities introduced a number of reforms in the legal
and judicial framework, including establishing commercial courts. However, much remains
to be done to develop an effective bankruptcy regime and a judiciary capable of encouraging
investor confidence. In recent studies by the World Bank, Indonesia ranked 5 on the scale of
1–10 for the “index of effective regulation on secured lending through collateral and
bankruptcy laws.” On procedures to enforce contracts, the World Bank found that
enforcement of contacts, including loan agreements is relatively more difficult in Indonesia
than in most countries. Legal limitations to the seizure of collateral property, together with
the relatively high cost and usually lengthy judicial process, reduce banks willingness to
lend, especially to corporates who have the financial resources to fight the banks in court.
102. Banks’ ability to expand lending is also impaired by weaknesses in information

infrastructure to facilitate assessment of borrower creditworthiness. In June 2006, BI
launched a credit information bureau for banks and financial institutions to use for managing
lending risk. However, the debtor information system, while helpful, does not include
information on a prospective borrower’s standing with nonbank institutions. With coverage
of only 0.1 percent of the population, the registry does not yet facilitate an adequate
assessment of borrower risk. Under these circumstances banks face difficulties screening out
sound from risky borrowers and this makes lending to small- and medium-sized firms and
consumers much more risky and difficult to justify.
103. The strengthening of prudential regulations could also have induced greater
selectivity in lending by banks and reduced lending. After the crisis, Indonesia made
greater strides to strengthen banking supervision, align the regulatory framework with
international practices and improve risk management capabilities in the banking sector,
especially in state-owned banks. In addition, the banks that were taken over by the
government and sold to foreigners have resulted in some of the largest private banks
introducing international risk management practices. Consequently, banks are more likely to
exercise greater prudence in lending than was the case prior to the crisis.
104. Until recently, the state banks faced additional hurdles in resolving their NPLs
and this overhang served as an additional deterrent to lending. Indonesia views the assets
of the state banks as state assets with the result that state banks were prohibited from writing
off loans, selling assets at a discount, or offering debt forgiveness as part of a loan
restructure. These limitations have been recently relaxed and guidance is being drafted to
permit the sale of assets at a discount, as well as restructurings that include debt forgiveness.
58
105. Finally, government paper may have “crowded out” of private sector credit to
some extent. In the aftermath of the crisis, banks’ commercial NPLs were transferred to the
government at book value and replaced with recap bonds. The net result was a marked
reduction of bank exposure to the private sector in favor of government paper. The share of
government paper (as a percent of total assets), though trending down, has continued to
remain high and there continues to be a strong appetite for BI paper among the banks. At the
state banks, the demand for BI paper has been compounded by a rapid increase in volatile
deposits resulting from fiscal decentralization.
D. Demand Factors
106. The sustained growth in GDP augurs well for long term demand for credit. Since
2000, real GDP has been growing at an average rate of 5 percent, driven largely by domestic
demand except for 2006 when it was export led. Credit demand would be expected to
increase with this increased level of economic activity since banks are the primary source of
commercial credit.53 However, growth has also not been sufficiently broad based to generate
sustained credit growth. Much of the lending to consumers has been for motor bikes while
the property sector, which in many countries has been the engine of consumer lending, has
stagnated, due to structural weaknesses
in the housing industry and housing
Indonesia: Real Lending Rates relative to other Asian
finance. Countries, 2001-2006
107. Borrowers have also faced 12

relatively high real lending rates. 10
During most of the post crisis period 8
real lending rates have been higher than
6
in neighboring countries. Real lending
Percent
4
rates have remained high and banks
issuing credit cards charge rates 2
annualized at about 26–42 percent. 0
Moreover, in August 2005 BI hiked -2

interest rates in a bid to curb -4
inflationary pressures. The combination 2001M1 2001M1 2002M1 2003M1 2004M9 2005M8 2006M7
Indonesia Korea Thailand
of higher interest rates and the increase
Malaysia Philippines
53
Domestic capital markets are not yet a significant source of financing for long term funds for Indonesian
corporates. The recent Supreme Court ruling regarding APP bonds is likely to make this financing even more
difficult and calls the legality of all corporate bonds into question Also, loan securitization is yet to develop.
Rather than provide long term finance to corporates, pensions and insurance firms currently invest a significant
portion of their resources in short-term bank deposits, in essence transforming scarce long term resources into
short-term assets.
59
in production costs resulting from higher oil prices led many firms to postpone investment
and reduced demand temporarily. During this same period defaults on credit cards and motor
bikes also peaked.54 Consequently, investment continued to decelerate through the end of
2005 after rebounding in the preceding year and the growth in lending to both consumers and
businesses declined sharply. Demand for credit from large corporates may also have been
constrained by the deleveraging that has occurred at many of these “groups,” as owners have
repatriated funds and invested them in their businesses, in lieu of borrowing from banks.
E. Is Credit Supply or Demand Constrained?
108. In analyzing the appropriateness of policy measures to stimulate credit growth

it is important to understand whether credit has been supply or demand constrained.
An econometric model was constructed to analyze private sector lending in Indonesia to
answer this question. The model uses many of the same determinants of the supply and
demand for credit discussed above. The theoretical underpinning for the model derives from
the work of Stiglitz and Weiss (1981). The underlying premise is that at a prevalent interest
rate, credit can still be supply constrained. Due to adverse selection, banks might choose to
apply quantitative rationing rather than increase lending rates due to the risk that higher
lending rates will attract only unworthy borrowers that are not expected to repay their loans.
Disequilibrium model
109. A disequilibrium model is used to investigate whether low real credit observed is
supply or demand constrained. Following a number of existing studies of credit rationing,55
a disequilibrium framework is used to investigate the behavior of real credit in Indonesia
during the period 1990–2006, as well as during the post crisis period. At any given time,
observed real credit could be due to low demand, low supply, or both. The disequilibrium
framework allows for the identification of the underlying constraints on credit in a switching
regression framework by imposing ex-ante different restrictions on supply and demand
functions.
110. At a given time, real credit supply does not have to equal credit demand, if
lending interest rates do not adjust sufficiently and or credit rationing occurs, or if
54
As of August 2005, credit card defaults were Rp 1.08 trillion or 7.2 percent of total credit card debt.
55
Pazarbasioglu (1997), Ghosh and Ghosh (1999), Barajas and Steiner (2002), and Canales-Kriljenko, and
Gelos, (2006) among others.
60
there are directed credits. The actual level of real credit will then be determined as
follows:56
s d (1)
C t =min(C t ,C t )
The choice of variables used to determine credit supply and demand are guided by Ghosh
and Ghosh (1999) who investigated real credit in Indonesia, Korea, and Thailand in the late
1990s, Canales-Krilijenko and Gelos (2006) who studied real credit in Uruguay after the
2002 crisis, and Barajas and Steiner (2002) who attempted to explain credit stagnation in
Latin America. The analysis in this case, however, is constrained by the limited availability
of potential explanatory variables with sufficiently long time series.
111. The supply of credit is modeled as a function of the spread between real lending
rate and banks’ cost of funds (rl – rd), banks’ lending capacity (l), and an indicator of
borrowers’ ability to repay (GDP, x).57
(2)
C t = β0 + β1 (rt − rt deposit ) + β 2s * lt + β3s * xt + ε td
s s s lending
112. The demand of credit is assumed to depend on real lending rate (r), current
output determining the need for working capital (y), output gap (ygap), an indicator of
future economic activity (stock market index, s), and inflation ( π t ).58
(3)
C t = β0 − β1 * rt + β2 * yt + β3 * yt + β4 * st + β5 * π t + εt
d d d d d gap d p d d
56
Following the method by Maddala (1974).
57
All data are quarterly and cover the period 1992:Q1 to 2006.Q1. Data sources include International Financial
Statistics and Biropustat Statistik. All variables are deflated by the Wholesale Price Index (2000=100).
Consistent with earlier studies and APD practice, the WPI was used as the deflator because it is more stable. All
variables are in logs, apart from the real interest rate and the output gap which is defined as the difference
between current output and trend output in percent of trend output. Inflation is defined as the percentage change
in the CPI over the previous quarter.
58
A simple measure of output gap is calculated following earlier studies using the Hodrick-Prescott filter to
estimate trend. Jakarta stock market index is used as an indicator of future economic activity. Inflation is
included to reflect the fact that borrowers benefit from inflation.
61
113. The probability that at any given time real actual credit is supply constrained is
determined as follows:
⎛ Ctd − Cts ⎞ (4)

θt = Prob(C > C ) = Φ ⎜ 2
D S
2 ⎟
⎝ σs +σd ⎠
t t
Where σ s and σ d are estimated standard errors of the credit demand and credit supply
equations and Φ [•] the cumulative Normal distribution function. Under this setting, one can
derive the density function h(Ct ) and the associated log likelihood function to be maximized
subject to the parameter values:
T
∑ log h(C )
i =0
i (5)
Maximization of the log likelihood function allows for estimation of credit demand and
supply equations and the probability that the observed credit is supply or demand
constrained. OLS is used to estimate the starting values for maximum likelihood estimation.
The goodness of fit can be gauged by how well the minimum of the estimated credit supply
and demand tracks the actual credit.59 As in previous studies the equations are estimated in
term levels, although observed real credit is not stationary. The results are valid as long as the
determinants of credit supply and credit demand are cointegrated, which is indeed the case.
114. The results suggest that in Indonesia, credit is demand constrained (see
Figure V.1 below and Table V.1 in the Appendix II). During the period immediately
following the crisis, credit demand substantially exceeded credit supply, with the probability
value of unity. However, following the crisis period both the supply and demand for credit
have increased but the results suggest that it is credit demand that is constraining actual credit
growth. These results are confirmed both by specifications covering the period from
1992 through 2006 and the post-crisis period beginning with the third quarter of 2000.
Figure V.1 is based on the specification (1) in Table V.1, Appendix II; however, different
specifications show a very similar picture.
115. For the post-crisis period the empirical analysis finds that most of the key
variables are significant and have the correct sign. In the demand equation the real
59
A measure of the robustness of a disequilibrium model is whether the probability that the underlying
hypothesis that credit is supply constrained approaches 1, and that if demand constrained the probability
approaches zero.
62
lending rate and the stock market index, are significant with the expected signs.60 In the
supply equation lending capacity is significant with the correct sign in most of the
specifications.61 In all specifications, measures of output were significant with the expected
sign. In all specifications that exclude the crisis period the interest rate spread is significant
with the expected positive sign. NPLs are significant with the expected sign for the time
period for which data is available.
60
Due to the limited number of observations for the post-crisis specification for credit demand, other variables
were excluded to assure sufficient degrees of freedom. In specifications that include the longer period, with and
without crisis, the output gap is also significant and with the correct sign.
61
In the specification covering only the post-crisis period lending capacity is insignificant. This is consistent
with the results for equation (4) where the lending capacity (more broadly defined) elasticity was very low.
63
Figure V.4. Indonesia: Empirical Estimation of Credit Demand and Supply 1/
12,000
Estimated Real Credit Demand and Supply versus Actual Credit
(In billions Rupiah, 2000 Prices)
10,000
Real credit supply
Real credit demand
8,000
Real credit
6,000
4,000
2,000
0
1995Q1
1995Q3
1996Q1
1996Q3
1997Q1
1997Q3
1998Q1
1998Q3
1999Q1
1999Q3
2000Q1
2000Q3
2001Q1
2001Q3
2002Q1
2002Q3
2003Q1
2003Q3
2004Q1
2004Q3
2005Q1
2005Q3
2006Q1
2006Q3
140 1
120 Excess credit demand, eq. (1) 0.9

100 Excess credit demand, eq. (2) 0.8
80
Probability that demand is higher 0.7
60 than supply, eq. (1), (RHS)
0.6
40
0.5
20
0.4
0
0.3
-20
-40 0.2
-60 0.1
-80 0
1995Q1
1995Q3
1996Q1
1996Q3
1997Q1
1997Q3
1998Q1
1998Q3
1999Q1
1999Q3
2000Q1
2000Q3
2001Q1
2001Q3
2002Q1
2002Q3
2003Q1
2003Q3
2004Q1
2004Q3
2005Q1
2005Q3
2006Q1
2006Q3
1/ Figure is based on specification (1) in the Table of Appendix II.

Notes: Excess credit demand is defined as the difference between credit demand and supply in percent of credit
supply, (Cd-Cs)*100/Cs, and presented on the left axis. Probability is one when credit is supply constrained and
zero when credit is demand constrained and is presented on the right axis.
64
116. Discussions with analysts and bankers confirm the finding that credit is
currently demand constrained. Analysts in Singapore and bankers in Jakarta who
uniformly indicated that there was a lack of demand for credit from credit worthy borrowers.
In fact, several banks noted that they had significant undrawn commitments to the
commercial sector. These commitments give the borrowers the right to borrow at pre-
specified terms and the fact that they have not been drawn down the loans indicates either
weak demand for credit by these borrowers or that they have access to alternative sources of
cheaper funds.
Conclusions from empirical work
• During the past few years lending has been demand constrained or close to
equilibrium. A limitation of this empirical work is that it does not capture the
demand for long-term credit. Aside from limited corporate bond financing, there has
been very little long-term lending in Indonesia and thus the data used in the analysis
presented above does not reflect the demand or supply of such credit.
• The credit risk associated with lending to the large corporates continues to be
problematic. Many of these firms, or their affiliates, continue to have NPLs in the
banking sector left over from the crisis and this has had a statistically significant
adverse effect on the supply of credit (in both models analyzed). There is a perception
that with a weak judicial framework that these borrowers will be able to block
enforcement of a loan agreement should they wish not to repay a loan. Moreover,
with BI’s stated intention to move toward Basel II, banks recognize that they will
have to hold additional capital against these loans.
F. Policy Conclusions
117. Inasmuch as the credit has been demand constrained, policies aimed at
increasing the supply of short-term lending will not be effective in stimulating loan
growth. Moreover, policies aimed at relaxing prudential norms away from those considered
to be consistent with international standards risk sending the wrong signal to banks and
supervisors.
118. Pressuring banks to make longer-term loans with no guaranteed short-term exit
will increase the liquidity risk in the system. Indonesian banks have an average maturity
on their liabilities of about one month. For these institutions to make long-term loans (even
with floating rates), in the absence of a secondary market, increases liquidity risk in the
system.
119. Given the relative underdevelopment of sources of long-term credit, there is

potential for stimulating increases in such lending. Anecdotal evidence suggests that there
65
is likely unmet demand for long term credit to finance infrastructure, housing, and other long
term projects. For example, in Jakarta buyers of condominiums must be able to pay the entire
cost of the apartment over three years, which clearly constrains demand to upper income
buyers.
120. The authorities need to move forward with measures to stimulate the creation of
a market for asset backed securities. The draft matrix of policies to enhance the financial
sector contains reference to measures that need to be taken to develop a mortgage backed
securities market. This could be expanded to cover other types of assets. The government
could also explore expanding the role of Ascrindo, a state owned loan guarantee company, to
include mortgages for lower-middle income borrowers. This, in conjunction with a secondary
market would help develop long term mortgage lending in Indonesia.
66
REFERENCES
Juda Agung (2002) “Credit Crunch in Indonesia in the Aftermath of the Crisis: Facts, Causes
and Policy Implications” Bank Indonesia, Jakarta.
Kusmiarso Bambang (2006) Housing and Mortgages Markets in the SEACEN Countries,
The South East Asian Central Banks (SEACEN), Kuala Lumpur, Malaysia.
Barajas, Adolfo, and Roberto Steiner, 2002, “Credit Stagnation in Latin America,” IMF
Working Paper 02/53 (Washington: International Monetary Fund).
Calvo, Guillermo A., Alejandro Izquierdo, and Ernesto Talvi, 2006, “Phoenix Miracles in
Emerging Markets: Recovering Without Credit from Systemic Financial Crises”
(Unpublished manuscript; Washington: Inter-American Development Bank).
Canales-Kriljenko, Jorge Iván, and Gastón Gelos, 2006, “Post-Crisis Credit: Facts, Lessons,
and Prospects,” IMF Country Report No. 06/427 (Washington: International
Monetary Fund).
Catao, Luis (1997) “Bank Credit in Argentina in the Aftermath of the Mexican Crisis: Supply
or Demand Constrained?” International Monetary Fund (WP/97/32).
Ghosh, Swati R., and Atish Ghosh, 1999, “East Asia in the Aftermath: Was There a Credit
Crunch?” IMF Working Paper 99/38 (Washington: International Monetary Fund).
Kiefer, Nicholas, 1980, “A Note on Regime Classification in Disequilibrium Models,”

Review of Economic Studies, Vol. 17, pp. 637–639.
Laffont, Jean-Jacques, and Rene García, 1977, “Disequilibrium Econometrics for Business
Loans,” Econometrica, Vol. 45.
Maddala, G., and Forrest Nelson, 1974, “Maximum Likelihood Methods for Models of
Markets in Disequilibrium,” Econométrica, Vol. 42, No. 6, pp. 1013–1030.
Pazarbasioglu, Ceyla, 1996, “A Credit Crunch? A Case Study of Finland in the Aftermath of
the Banking Crisis,” IMF Working Paper 96/135 (Washington: International
Monetary Fund).
Sealey, C.W., 1979, “Credit Rationing in the Commercial Loan Market. Estimates of a
Structural Model under Conditions of Disequilibrium,” Journal of Finance, Vol. 34,
pp. 689–702.
67
Stiglitz, Joseph, and Andrew Weiss, 1981, “Credit Rationing in Markets with Imperfect
Information,” American Economic Review, Vol. 71, pp. 393–410.
Tornell, Aaron, and Frank Westermann, 2002, “The Credit Channel in Middle Income
Countries,” NBER Working Paper No. 9355, (Cambridge, Massachusetts: National
Bureau of Economic Research).
World Bank (2006) “Unlocking Indonesia’s Domestic financial Resources: the role of
Non-Bank Financial Institutions,” Washington DC.
68
APPENDIX I: DETERMINANTS OF LONG- AND SHORT-RUN SUPPLY AND DEMAND FOR

CREDIT
The long run model
121. The supply of bank credit is specified as a log-linear function of the lending capacity
of the banking system (LC) and of the lending interest rates (i) as follows:
S = α0 LC α 1 i α2εs (6)
Where ε is an error term.
The long-run demand for credit is a positive function of GDP and negatively related to the
interest rate,
D = ß0 GDPß1 i –ß2 εd (7)
And in the long run, supply and demand for credit converges.
S = D = Actual Credit (8)
The short run model
122. The short run specification of the model is derived by applying the log operator and
taking the first difference of equations (6) to (8), and adding to these equations any extra
variable which may have a short run impact on credit. The analysis in Section III highlighted
the factors that impact on credit supply to include the credit risk of the corporates, the banks
balance sheet structure, crowding out by the government, the legal and judiciary framework,
weaknesses in information infrastructure, and bank regulations. Unfortunately, there are no
available indices to capture trends in many of these variables and the developments do not
lend themselves to being proxied by dummies.
123. Thus, the empirical specification used for the short run version of the supply
equation (5) is:
ΔSt = α10 + α11 Δ LCt + α12 Δispreadt - α13 Δ (NPL ratio)t - α15εs-1 + Ut (9)
Where St is private sector credit, LC is lending capacity of banks defined as deposits and
foreign liabilities, ispread is the interest rate spread computed as the difference between
69
lending and deposit rates, NPL ratio denotes the credit risk, ε is the residual of equation (6) or
2
“error correction term” and U is a normally distributed residual term, Ut ̃~N(0,σu ).
By postulating that current changes in credit supply respond to deviations between the actual
level of credit and its long run supply, the error correction term ensures consistency between
the short and the long run results of the model.62
124. Similarly, the short run credit demand is specified as:
ΔDt = ß10 + ß11E( Δ GDP)t - β12 Δit - β13 excessdebtt - β14 εt +zt (10)
Where E (GDP) is the expected output which is proxied by a production index, i is the
lending rate, excess debt is measured by the deviation of private sector debt from its long
run trend and ε is the estimated residual of equation (7), i.e., an error correction.63
125. The equations were estimated using a Vector Error Correction Model (VECM) and
Least Squares estimation (OLS). The sample period is 2001M1-2006M12. The empirical
investigation began with an analysis of the time series properties of the variables. The
augmented Dickey-Fuller (ADF) test and the Phillip Perron (PP) tests were used to determine
the order of integration of the data compiled for each variables (see Appendix for the results).
Following on this procedure, we applied the Johansen (1995) cointegration methodology.
The VECM has the distinct advantage of ensuring consistency between the long run and the
short run equations through the error correction term.
126. The results are presented in the tables below. Appendix Table 1 presents the
results for the short-run supply and demand equations and Appendix Table 2 presents the
results for the long-run specifications
62
Ideally, the equation should have included dummies for regulations, the legal framework for contract
enforcement and credit registry, but these were omitted due to insufficient information on how they have
progressed.
63
Ideally, the short run demand equation should have included unemployment among the explanatory variables,
but data limitations precluded this possibility.
70
Table 1: Indonesia: Determinants of Private Sector Credit

Results of the Ordinary Least Square(OLS) estmation
Demand model Supply model

Coefficient P-value Coefficient P-value
d(GDP ) (+1) 0.04 0.08

d(i) -0.02 0.02*
d(i_spread) (-2) 0.01 0.23
d(PSC) (-2) 0.08 0.35
Excess debt 0.07 0.00**
d(Lendcap) (-1) 0.15 0.00**
d(NPL) (-5) -0.03 0.01*
ECT 1.06 0.00** 0.97 0.00**
constant 0.01 0.00** 0.01 0.00**
No. of Obs. 68 65
Adjusted R-squared 0.50 0.81
DW statistic 1.75 1.93
Breusch-Godfrey LM test 1.47 0.24 0.06 0.94
Jarque-Bera test 0.38 0.82 1.00 0.61
Skewness -0.18 -0.28
Kurtosis 3.02 2.78
1/ All variables are in logarithms, with the exception of interest rate and interest spread.
* and ** denote 5 and 1 percent significance, respectively.
The results of the long-run model confirm the existence of a significant relationship between
the variables. The results are consistent with the theoretical model and the estimated
coefficients have the expected signs and are statistically significant at 5 percent or very close.
The model also proved to be robust to a number of specification tests for autocorrelation and
unit root of the residuals.
71
APPENDIX Table 1: Results of Different Specifications of the Disequilibrium Model for

Real Credit
(1) (2) (3)
Demand function
Constant 20.70* 7.99*** 18.30***
(1.85) (78.84) (4.69)
Real lending interest rate -0.01* -0.01*** -0.97***

(1.65) (4.54) (2.70)
Stock market index 0.73*** 0.22*** 0.37***

(3.38) (4.38) (5.30)
Output gap 0.01 --- 0.03***

(0.43) --- (4.15)
Real output -1.06 --- -0.82**

(1.19) --- (2.77)
Inflation 0.23 --- -0.41

(0.21) --- (0.34)
Sigma 0.17*** 0.03* 0.04***

(5.49) (1.77) (4.28)
R² (OLS) 0.83 0.55 0.93
Supply function
Constant 4.97*** -20.14*** -8.64***
(7.53) (7.37) (3.40)
Interest rate spread -0.04*** 0.02*** 0.03**

(6.35) (3.41) (2.16)
Lending capacity, lagged 0.08*** 0.53 1.59***

(18.04) (0.02) (7.65)
Industrial production, lagged 0.67*** --- 0.72***

(4.70) --- (2.68)
GDP, lagged --- 2.19*** ---

--- (6.30) ---
NPL ratio to total credit, lagged --- -0.66* ---

--- (1.71) ---
Pre and post crisis dummy --- --- 0.19

--- --- (1.43)
Sigma 0.07*** 0.02* 0.05***

(3.19) (1.66) (3.60)
R² (OLS) 0.54 0.94 0.95
Log likelihood 42.67 52.18 69.53
1992:Q1-2006:Q4;
Period covered 1992:Q1-2006:Q4 2000:Q3-2006:Q4 excluding crisis period
Notes: All variables are deflated by the WPI; all variables are in logs expect for real interest rates.
t-statistics in parenthesis; *, **, and *** represent significance at 10, 5, and 1 percent respectively.
72
VI. INDONESIA: CREATING FISCAL SPACE64
A. Introduction
127. In Indonesia, the government’s key policy priorities require the creation of fiscal
space to increase spending on health, education, and infrastructure. Over the past five to
ten years, fiscal policy has been geared toward consolidation and reducing the high public
debt ratio. More recently, the government has taken significant measures, especially through
reducing domestic fuel subsidies, to increase spending in priority areas at both the central and
local government levels, with a view to improving social indicators and alleviating key
bottlenecks to growth. However, significant additional spending may be needed to achieve
the government’s growth targets of about 7 percent in the medium term, and to reduce
poverty from the current 18 percent level. At the same time, the government may need to
deal with some decline in oil revenues.
128. In its broadest sense, fiscal space can be defined as the availability of room in the
budget that allows a government to provide resources for priority purposes without
undermining fiscal sustainability.65 Fiscal space can be generated through: (i) measures to
raise revenue, such as broadening the tax base and improving compliance; (ii) reallocation of
expenditures; and (iii) higher deficits, as long as this does not undermine fiscal sustainability.
In cases where public resources are insufficient to meet priority spending needs, private
sector participation in the provision of public goods can provide an alternative, if a proper
institutional framework is in place.
129. Drawing on Indonesia’s policy challenges and key priorities, this paper attempts
to answer the following questions: (i) why is more fiscal space needed in Indonesia?
(ii) what can be done to expand fiscal space at the central government level? and (iii) what
measures can increase fiscal space at the local government level? Results indicate that fiscal
space available at all levels of government could be sizable. The sectoral expenditure
analysis in this paper is to a large extent based on recent comprehensive World Bank studies,
including the 2007 Public Expenditure Review.
B. Why is More Fiscal Space Needed in Indonesia?
130. Additional spending on social programs is needed to improve Indonesia’s

poverty and social indicators. While considerable progress has been achieved in the last
64
Prepared by Amine Mati (FAD, Ext. 37797).
65
Heller, P., 2005, “Understanding Fiscal Space”, Policy Discussion Paper, N05/4, (Washington DC:
International Monetary Fund).
73
decade (Annex VI.1), comparisons with other Southeast Asian countries show Indonesia as
having a large share of near poor.66 Similarly, access to quality health, education, and other
basic services is weaker, which is consistent with a lower per capita income (Table VI.1).
Table VI.1. Some social indicators: Indonesia and Comparator Countries 1/
Poverty: (less Poverty: (less Primary Secondar Under 5 child Maternal

than 1 US$/day , than 2 US$ a education y mortality (per mortality ratio (
headcount ratio, day, headcount (Gross %) enrollment 1000) per 100k live
Indonesia 8.5 49 82 52.9 46 307

Malaysia ... ... 91 70 12 41
Philippines 15 43 97 84 34 200
Thailand 2 32 na 77 21 44
Vietnam 2 26 101 74 23 130
E. Asia Pacific ... 34 99 69 37 117
Lower Middle Income ... ... 98 72 40 153
Source: World Bank MDG Atlas as retrieved on June 8, 2007. World Bank estimates.
1/ For 2006 or most recent year where data is available.
Notwithstanding recent increases, Table VI.2. Total Public Expenditures 1/

Indonesia spends less on both (In percent of GDP)
education and health (as a
Health Education
percentage of GDP) than
comparable countries in the region Indonesia 0.9 2.8
Thailand 3.3 4.6
(Table VI.2). In addition, pressures Malaysia 3.8 8.1
to increase total spending on Philippines 3.2 3.1
education are likely to rise in the Vietnam 5.4 ...
India 4.8 ...
future as they are estimated at only
Source: WDI, World Bank Public Expenditure Review (2007).
17 percent of total expenditures,
while both the constitution and the 1/ For 2004. This is the most recent year where local government data
is available.
law on the national education
system stipulate that a minimum of 20 percent of the central and regional budget, exclusive
of salary costs, be spent on education.67
131. Relatively low infrastructure investment is regarded as a key bottleneck to faster

economic growth.68 Indonesia’s overall central government investment level has hovered
66
49 percent of the population lives with less than US$2 a day. This is high relative to the comparable average
for the East Asia region (at 34 percent).
67
Using 2004 data, it is estimated that an additional Rp 62 trillion would be needed to meet that target, which
would have been equivalent to 13.9 percent of total government spending in 2004.
74
around 2–3 percent of GDP since the advent of decentralization in 2001. In recent years
actual spending has fallen well below budgeted amounts as a result of weak project
preparation and implementation, and significant delays in the budget process, including
because of new budget execution procedures and reorganization of the Ministry of Finance.69
Moreover, a comparison of central government investment levels across countries shows that
Indonesia’s levels have been lower than in some neighboring countries (e.g., Malaysia or
Vietnam). An increase in public investment would aim at:
• Filling large infrastructure needs. Infrastructure is increasingly seen as one of the

key constraints to growth and poverty reduction. Total private and public annual
infrastructure investment, including by public enterprises and local governments, fell
from a pre-crisis high of 6 percent of GDP to a historical low of about 2–3 percent of
GDP following
the crisis. This
Table VI.3. Regional Ranking for Access to Infrastructure Services
led to a rapid
deterioration of Infrastructure Indonesia Regional Rank
Indonesia’s Electrification ratio 53% 11 of 12
infrastructure Access to sanitation 55% 7 of 11
indicators, which Access to clean Water 14% 7 of 11
Road network (km per 1000 people) 1.7 8 of 12
have now
Source: Indonesia World Bank PER (2007).
become some of
the weakest in the region (Table VI.3).
• Compensating for limited private sector participation in infrastructure. The

vacuum left by the sharp fall in public infrastructure investment during the crisis was
not filled by private infrastructure investment. While the government is attempting to
address this issue through improvements in the investment climate and forging
partnerships with the private sector, this is a protracted process—none of the
91 projects identified in the 2005 infrastructure summit have been finalized yet.70
68
Central government investment is measured by “development spending”, which comprises both capital and
social spending. This is the best proxy for measuring investment as capital spending is only available starting in
2005 once the unified budget has been introduced. Data on regional development expenditures are not yet
available, but these were reported to amount to 2.5 percent of GDP in 2004.
69
On average, about 50 percent of total development spending is still effected in the last quarter of the year.
70
Main bottlenecks are uncertainties surrounding the legal system and weak project preparation. The
government has tried to address these issues by introducing a new institutional framework that encourages
careful project preparation, with open and transparent bidding and appropriate risk assessment, along with a
limit on government’s risk exposure. However, this framework will need time to fully bear fruit.
75
C. How has Fiscal Space Evolved Since 2001?
132. Several policies since 2001 have contributed to Indonesia’s fiscal space:
• Higher non-oil revenues. Total revenues increased to 19 percent of GDP in 2006

(from 18.3 percent of GDP in 2001), with higher non oil and gas tax revenues
compensating for the slight decline in oil and gas revenues.71 Given the volatility in
oil revenues and their expected decline, the government has aimed to increase non-oil
and gas tax revenues through gains in tax administration and some broadening of the
tax base. This has led to a significant increase in non oil and gas tax revenues to
11 percent of GDP in 2006 (from 9.9 percent of GDP in 2001).
• Decreasing interest payments. The interest rate bill, at 2.4 percent of GDP in
2006, has been halved since 2001 and only represents 12 percent of total expenditures
(compared to 30 percent in 2001). This corresponds to a halving of the public debt
level to 39 percent of GDP by end-2006, resulting from the government’s fiscal
consolidation strategy, as well as non-debt financing such as financial asset sales
from the bank restructuring agency (IBRA).
• Declining energy subsidies. Spending on fuel subsidies, which are regressive except
for kerosene, reached 4.4 percent of GDP in 2005 (compared to 3 percent of GDP in
2001) as fuel prices remained fixed while international oil prices soared. Sharp fuel
price increases in 2005 (both in March and October, combined with the introduction
of market prices for industry sales in July 72) reduced those subsidies to 1.9 percent of
GDP in 2006.
• Small decline in personnel spending. Despite the 45 percent increase in the base
wage between 2001 and 2006, personnel spending fell slightly as a share of GDP
(0.2 percent) during that time. Currently, Indonesia spends about 10 percent of all
expenditures on remuneration of government employees.
71
Despite international crude oil prices increasing from US$24 a barrel to about US$60 a barrel, oil and gas
revenues remained about stagnant at about 6 percent of GDP (from 6.3 percent in 2001) and about 30–
35 percent of total revenues, mainly because of a 30 percent decline in oil production over the period.
72
The October increases were especially sharp, with gasoline prices raised by 88 percent, diesel by 105 percent
and kerosene by 186 percent.
76
133. However, with weak budget execution in the last few years, revenue increases
and gains from expenditure Table VI.4. Indonesia: Central Government
rationalization resulted in lower Fiscal Space Under Current Baseline
( Change during periods, percent of GDP)
deficits. The overall deficit fell from
3.2 percent of GDP in 2001 to 2001-2006 2006-2012
1 percent of GDP in 2006. Meanwhile, Revenues 0.7 -2.3
Oil and Gas -0.3 -2.8
the advent of decentralization in 2001, Non oil and Gas 1.0 0.5
which led to the devolution of most of Current Spending -1.7 -3.6
the health and expenditure programs, Personnel -0.2 1.1
Interest -3.3 -1.6
increased regional transfers and Transfers to Regions 1.9 -0.9
reduced fiscal space at the central Subsidies -1.5 -2.1
government level, but substantially Goods and services 1.4 -0.2
Overall Balance 2.2 0.4
increased space at the regional level
Fiscal space 1/ 0.2 0.8
(Section E). Overall, staff estimates
Source: IMF Staff Estimates
that fiscal space at the central 1/ A change in fiscal space is defined as improved
government level increased by only revenue mobilization, reduction in current spending
0.2 percent of GDP during 2001–06 (discretionary and non discretionary) and increase in
the deficit. A positive number implies a positive
(see Table VI.4). contribution to fiscal space.
D. What Can Be Done to Increase Central Government Fiscal Space?
134. Under current policies, the fiscal space of the central government could increase
by about 1 percent of GDP over the next five years. A reduction in spending is projected
to be the largest contributor to the change in fiscal space (Table VI.4) with: (i) interest
payments declining to 0.8 percent of GDP, as public debt is expected to fall to 26 percent of
GDP; and (ii) some reduction in fuel subsidies assumed from 2010 onwards (following the
general elections). Absent new policy measures, the expansion of the fiscal space beyond
1 percent of GDP is limited by:
• Lower Tax Revenues. The implementation of tax laws recently approved by

Parliament, as well as those still before Parliament, should help to both enhance
revenues through better tax administration and improve the business climate.
However, tax cuts are also envisaged, which would reduce revenue by about 0.6–0.8
percent of GDP by 2010. Such losses would arise mostly from cuts to the personal
and corporate income tax rates and possible additional VAT exemptions.73 Losses
73
Main changes include: (i) reduction of the PIT rate from 35 percent to 33 percent in 2008 and to 30 percent
by 2010; (ii) reduction in the number of brackets for the PIT from 5 to 4; (ii) change in the corporate income tax
rate from 3 brackets to a single rate of 30 percent; and (iii) reduction of the CIT rate from 30 percent to
28 percent in 2008 and 25 percent in 2010.
77
could be higher, depending on the implementation of tax incentives included in the

tax package and the investment law.
• Lower Oil and Gas Revenues. These are expected to be halved to about 3 percent of
GDP in 2012, or about 18 percent of total revenues. These projections assume oil
prices declining to US$63 a barrel (a 25 percent reduction in real terms) and some
increase in oil production reflecting the coming on line of the Cepu Oil field74. The
impact of lower oil prices on fiscal space would be offset by lower subsidies and
transfers to regions.
• The need for continued fiscal discipline. The overall fiscal deficit is expected to fall
slightly below 1 percent of GDP by 2012, allowing for continued reduction in the
debt-to-GDP ratio (to about 26 percent of GDP). Such a policy would help to keep
public debt sustainable even in the event of severe macroeconomic shocks.
135. Several options are available to create fiscal space at the central government
level without higher fiscal deficits. The government is focusing on its continuing program
to improve tax administration, which is expected to increase revenues by at least 0.2 percent
of GDP a year following the modernization of medium taxpayers offices and the revamping
of audit procedures—this yield is included in the baseline scenario shown in Table VI.4.
However, as efforts to improve tax administration are likely to take effect only gradually,
another option would be to increase non-oil and gas tax revenues, which are still low by
international standards. Over time, additional yields of at least 1 percent of GDP on an
annual basis (staff estimates) could be generated through:
• Limiting VAT exemptions. VAT, with a single 10 percent rate, is a major source of
revenue for Indonesia, currently accounting for about 20 percent of revenues.
However, many products continue to be exempt, including under upcoming
legislation. The removal of a number of exemptions could be considered as a VAT is
most effective when applied to virtually all goods and services at a uniform rate.
Examples include mining, electricity (only households with meter capacity above
6,600 watts are taxed), agriculture, clean (piped) water, hotels and restaurants.
Removing such exemptions could increase revenues by about 0.3 percent of GDP
(staff estimate).
• Adjusting property tax rates. An increase in the land and building tax could be
considered. Properties are assessed on an annual basis and the taxable value does not
74
The decline appears large relative to output, as nominal GDP is expected to almost double by 2012.
Projections for 2012 assume the same cost oil assumptions as those used in the 2007 budget.
78
exceed 40 percent although they are allowed by law to be equal to 20–100 percent of
the assessed value. Currently, the annual component of land and building taxes
produces relatively little revenue (about 0.4 percent of GDP), with most of the intake
coming from industrial sectors, such as mining.
• Introducing a fringe benefits tax. The main source of non-oil and gas revenues in
Indonesia are income taxes, mostly personal and corporate income taxes. Under the
1983 income tax reform, in-kind fringe benefits (company provided housing, motor
vehicles, etc.) are not taxed and companies are no longer allowed to deduct the cost of
these benefits. Some countries (e.g., New Zealand or the Philippines) have dealt with
the problem of in-kind fringe benefits by imposing a separate fringe benefits tax
usually at the highest marginal tax rate for individuals. All employers are subject to
this tax, including loss making firms, as it is imposed in lieu of taxing employees
directly on their fringe benefits. Such a measure, especially if the tax is charged at the
highest marginal rate for individuals (and paid by all employers), could result in
sizable revenues in Indonesia.75
136. The rationalization of current expenditures could also provide additional room
for priority spending. Indonesia has a very uneven distribution of expenditures. Spending
on interest, subsidies, personnel (outside of education, and health) and government apparatus
and supervision, represents about one-half of all government expenditures. That trend is
expected to continue in the future, thus limiting priority spending on infrastructure, health,
and education.76 According to staff estimates, efficiency gains, along with an elimination of
the energy subsidies, could expand fiscal space by an additional 1.5 percent of GDP:
• Efficiency of spending. Substantial savings in expenditures could materialize

through efficiency gains though they are difficult to quantify. For example, in both
the health and education sectors, the most immediate challenge is to better coordinate
across all levels of governments to avoid duplication of tasks. Another challenge in
the health sector would be to channel spending to areas of most benefit to the poor.
Currently, health resources are mostly directed to services predominantly used by
higher income quintiles, or for salaries of health providers (World Bank, 2007). In
addition, improvements in the procurement process and a simplification of budget
execution procedures could reduce costs associated with project preparation and
75
Potential valuation methods for fringe benefits could typically include the rental value of housing owned or
rented by employer, percentage of the cost of the vehicle or school fees provided to the employee. It was not
possible to calculate the potential revenue impact given the lack of information on in-kind benefits.
76
While education and health functions have been devolved to local governments, about 60 percent total
development expenditures in these sectors still comes from central government.
79
implementation (as was the case in 2006 when improvements in procurement

reportedly led to savings in certain budgetary lines).
• Government apparatus. Indonesia’s spending on general administration is expected

to remain at about 15 percent of total expenditures, which is relatively high compared
with other countries. Some savings in this area could materialize especially if civil
service reforms are implemented, including through modifying the compensation
package and developing clear job descriptions and service standards (World Bank,
2007).
• Subsidies. An increase in average fuel prices77 could help to reduce fuel subsidies and
free up to 1.2 percent of GDP in additional resources, although some of the gains
would need to be spent on compensatory programs to avoid a negative impact on the
poor. The introduction of an automatic price adjustment mechanism could safeguard
fiscal space in the future. Additional gains could also stem from improving the
efficiency of the electricity company, as intended by the authorities. A 10–40 percent
increase in electricity tariffs could help reduce these subsidies by about 0.2–
0.6 percent of GDP in the medium term. However, care has to be undertaken in
designing the tariff rate increase as Indonesia has five types of subsidies, which affect
the poor differently.78
E. Local Governments and Fiscal Space
137. Fiscal space at the local government level has increased by about 0.8 percent of
GDP since 2001 (Table VI.5). While estimates for regional governments’ financial
operations have to be taken with caution given data limitations for 2005 onward,79 the
77
Staff estimates that an additional 10–40 percent increase in average fuel prices would reduce fuel subsidies by
0.3–1.2 percent of GDP by 2012.
78
The most important type of subsidy is the one that allows for low intensity electricity (450 volt capacity) and
provides the most benefit to the poor. Thus, the regressive nature of the electricity subsidy should be reduced by
increasing rates for other subsidy types (i.e., use of 900 VA to 6600 VA).
79
Details on subnational revenues and expenditures are available only to 2004. Data for 2005 and 2006 were
extrapolated from financing information (regional government deposits) and from known revenue transfers.
Expenditure composition for 2005–06 is assumed the same as in 2004.
80
increase in fiscal space is mostly explained by an increase in central government transfers80

from 5 percent of GDP in 2001 to about 6.8 percent of GDP in 2006. This reflects higher
budgeted oil prices, as well as
Table VI.5. Indonesia: Fiscal Space at the Regional level 1/
increased ad-hoc revenue sharing (Change during periods, percent of GDP)
arrangements granted to provinces
2001-2006 2/
such as Aceh and Papua, and the
implementation of the hold harmless Total revenue and grants 1.8
Own revenue 0.2
provision.81
Total transfer from central government 1.9
Other -0.2
138. The expansion of priority Current Spending 3/ 0.5
spending at the local level, especially Overall Balance 0.5
Fiscal Space 0.8
on health and education, was Source: IMF staff estimates.
however limited by: 1/ A change in fiscal space is defined as improved revenue
mobilization, reduction in current spending (this may however include
some spending on salaries on teachers and health workers) and
• Regional governments’ increase in the deficit. A positive number implies a positive
contribution to fiscal space.
inability to spend their full
2/ Actual data on regional government is available until 2004. Data for
budgets. Regional 2005-2006 are staff projections, based mostly on available financing
information (i.e., local governments' deposit accumulation).
governments ran large
surpluses during the last five years, leading to substantial deposit accumulation. As of
end-March 2007, the stock of regional government deposits, held at commercial
banks reached 2.8 percent of GDP and is expected to grow to 3 percent of GDP by
end- 2007. The low spending at the local level reflects planning delays and
implementation capacity constraints, as local governments are unable to keep up with
large revenue increases.
• Higher spending on personnel and other administration expenses. Even after

excluding salaries for education and health personnel, the current level of expenditure
on administration at the local level is high (at about 30 percent of regional
spending),82 reflecting in part the creation of more than 100 new districts over the
period (an increase of 30 percent from 336 districts in 2001 to 437 in 2006). The
80
Intergovernmental fiscal transfers are fixed at budget time and comprise three elements: (i) shared revenues
(tax and nontax); (ii) a non earmarked general allocation grant (DAU); and (iii) an earmarked special allocation
grant (DAK). The largest component of the transfers is the DAU, which is currently 26 percent of net domestic
revenues (net of revenue sharing).
81
This provision, introduced with the advent of decentralization, ensures that no district or province receives
transfers that were less than in the previous year. This provision is expected to be removed in 2008.
82
Largest items in administrative spending include salaries and allowances for the local and parliamentarians as
well as public office building rehabilitation and construction.
81
World Bank estimates that only 5 percent or less of the budget should be allocated to
such expenses, which is the norm in most countries.
139. Priority spending at the local level could be increased considerably in the next
few years. The government recognizes that there is considerable fiscal space at the local
level and substantial room for improvement in the use of its resources. It is currently
pursuing policies aimed at increasing overall spending using regional governments’ large
accumulated surpluses and reorienting the current budget allocation towards infrastructure
and the health and education sectors.83 Policies to be considered include the use of:
• Better budget allocation. Future delivery of public funds from the central
government, especially targeted grants, could be linked to certain investment
thresholds being met by local governments, or the improvement of performance in
certain key sectors (i.e., water provision, road infrastructure, and education
outcomes).
• Co-financing schemes and fiscal incentives. Central government’s financing of sub-

national infrastructure projects (i.e, roads) could be made conditional on local
governments’ participation, including through providing adequate road maintenance
or electrification in that area.
• Improved public financial management practices at the regional level. In addition

to increasing the volume of priority spending, improving its effectiveness remains a
key issue. Inefficiencies in the budgeting process need to be overcome, including
through streamlining of budget approval processes, more regular transfers of
resources to local governments and improving local governments’ capacity to plan
future investments (i.e., investments are commonly done on an ad-hoc basis and not
linked to medium-term plans or budget projections).
F. Conclusions
140. Indonesia needs to create fiscal space to help meet its ambitious infrastructure
and poverty reduction goals. Over the recent past, the expansion of priority spending has
been modest as: (i) budget execution problems have resulted in revenue increases and
savings on subsidies being mainly used to pursue the central government’s fiscal
consolidation strategy; and (ii) subnational governments continued to accumulate large
83
While local governments are expected to spend more on education and health, including through higher
investment, the central government still plays an important role as it spends about 14 percent of its budget in the
education sector alone. The government is currently working on new regulations that would better delineate
expenditure responsibilities across different levels of government.
82
surpluses as local implementation capacity did not keep up with the large increase in central
government transfers. Looking ahead, expansion of fiscal space is essential to meet the
country’s large infrastructure and social needs. This can be done without affecting public
debt reduction goals. In this regard, the following measures could help to create additional
fiscal space:
• Central government. In addition to ongoing efforts to improve tax administration,

new tax policy initiatives could be considered to quickly bring a sizable increase in
non oil and gas taxation, while further gains in spending efficiency combined with a
reduction in subsidies could provide further fiscal space.
• Regional governments. Improved budget allocation along with better public

financial management systems would lead to substantial efficiency gains and allow
for increased use of the regional governments’ accumulated deposits on key priority
areas.
83
REFERENCES
Clements, Benedict; Jung Hong-Sang, and Sanjeev Gupta. “Real and Distributive Effects of
Petroleum Liberalization: The case of Indonesia,” IMF Working Paper, N03/204
(Washington DC: International Monetary Fund).
Government of Indonesia, 2004, RPJM-Medium-term Strategic Plan 2004–2009 (Jakarta).
Heller, P., 2005, “Understanding Fiscal Space,” Policy Discussion Paper, N05/4
International Monetary Fund, 2002, Indonesia: Republic of Indonesia: Tax Policy, Tax
Administration, and Customs administration Reform: Volume I. Tax Policy”
International Monetary Fund, 2005, “Indonesia: A Due Diligence Review of Pending Tax
Reform Proposals”. Technical Assistance Report (Washington, DC: International
Monetary Fund).
International Monetary Fund, 2006, “Indonesia: Report on Observance of Standard and
Codes-Fiscal Transparency Module” (Washington DC: International Monetary
Fund).
International Monetary Fund, 2007, “Indonesia: Technical Note on Statement of Fiscal
Risk,”. mimeograph (Washington DC: International Monetary Fund).
Lewis, Blane, 2005, “Indonesian Local Government spending, Taxing and Saving: An
Explanation of Pre- and Post decentralization Fiscal Outcomes,” Asian Economic
Journal, 19(3), pp. 291–317.
Lewis, Blane and Jasmin Chakeri, 2004, “Central Development Spending in the Regions
Post-Decentralization,” Bulletin of Indonesian Economic Studies, Vol. 42, n3.
World Bank, 2005, Papua Public Expenditure Analysis: Regional Finance and Service
Delivery in Indonesia’s Most Remote Region (Jakarta: World Bank).
World Bank, 2006a, “Fiscal Policy for Growth and Development: an Interim Report
Prepared for the Development Committee Meeting, April 23 (Washington DC: World
Bank).
World Bank, 2006b, Making Services Work for The Poor (Jakarta: World Bank).
World Bank, 2006c, Making the New Indonesia Work for the Poor. (Jakarta: World Bank).
World Bank, 2006d, Ukraine: Creating Fiscal Space for Growth: A Public Finance Review”.
(Washington DC: World Bank).
World Bank. February 2007. “Spending for Development: Making the Most of Indonesia’s
New Opportunities”. Public Expenditure Review. (Jakarta: World Bank).
84
Annex 1. Indonesia: Selected Social Indicators, 2001-06
2001 2002 2003 2004 2005 2006
Education
Elementary school net enrollment ratio, percent of relevant aged group 92.9 92.6 92.6 93.0 93.3 ...
Population > 10 yr old not completed primary school (percent) 34.4 31.3 30.8 29.4 29.3 ...
Population > 10 yr old finished primary and Junior high school (percent) 47.6 49.2 47.1 49.9 49.4 ...
Population > 10 yr old finished high school and college (percent) 18.0 19.5 11.5 20.7 21.3 ...
Adult literacy rate 89.3 90.7 90.9 90.5 90.9 ...
Health
Life expectancy rate 66.2 66.2 66.2 68.6 67.8 ...
Fertility rate, births per woman 2.3 2.3 2.3 2.3 2.3 ...
Children < 5 yr old that have good nutrition (percent) 69.1 71.9 69.6 74.4 68.5 ...
Children < 5 yr old that had been immunized (percent) 89.9 90.6 ... 92.1 ... ...
Housing and Sanitation
Household with access to piped water (percent) 18.3 19.7 18.9 18.0 18.0 ...
Household with electricity (percent) 86.3 87.6 87.9 89.0 ... ...
Poverty and inequality

Number of people under poverty line (in millions) 37.9 38.4 37.3 36.1 35.1 ...
Population under poverty line (in percent) 18.4 18.2 17.4 16.7 16.0 17.8
Gini Coefficient 0.32 0.33 0.32 0.33 0.33 ...
Employment
Total labor force (in millions) 99 101 100 104 107 ...
Labor participation rate+A20 68.6 67.8 65.7 67.6 68.0 66.2
Unemployment rate 8.1 9.1 9.5 9.9 10.3 10.3
Sources: World Bank and CEIC Database.

Indonesia Selected Issues - IMF Country Report 07

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Indonesia Selected Issues - IMF Country Report 07

Uploaded by

Copyright:

Available Formats

© 2007 International Monetary Fund August 2007

IMF Country Report No. 07/273

Indonesia: Selected Issues

Copies of this report are available to the public from

International Monetary Fund ● Publication Services

Price: $18.00 a copy

International Monetary Fund

Prepared by Nita Thacker, Christopher Crowe, R. Armando Morales (both APD),

Approved by the Asia and Pacific Department

June 27, 2007

IV. Building a Financial Safety Net in Indonesia ..............................................................35

V. Post Crisis Credit Expansion in Indonesia...................................................................50

VI. Creating Fiscal Space...................................................................................................72

5. Improving financial intermediation has been a priority of the authorities. In

B. Regional Trade Integration

Trends in Trade Integration

economies have relied on an export oriented 100

openness ratios in excess of 100 percent,

including Hong Kong SAR, Malaysia, g

Sources: IMF, World Economic Outlook ; and Fund staff calculations.

Table II.1. Indonesia's Trade Integration with Asia

Indonesia's imports from: Indonesia's exports from

1990-95 1996-99 2000-05 1990-95 1996-99 2000-05

Asia 54.9 54.3 61.3 64.0 60.5 64.1

Non Industrial Asia 25.8 30.0 41.8 30.3 34.3 38.8

Brunei Darussalam 0.0 0.0 0.6 0.1 0.1 0.0

Industrial Asia 29.1 24.4 19.5 33.7 26.2 25.3

Source: IMF, Direction of Trade Statistics.

10. Intraregional trade in Asia has

trade, whereas it accounts for about 64 60

percent of Indonesia’s trade (Figure II.2). 55

11. Despite the recent robust export 8 60

Moreover, it has lost market share in both 1

non-oil exports and manufactured products 0 0

since 2000. Of its key export markets,

and Thailand. Using disaggregated trade 20

data from Comtrade, the change in the -60 -40 -20

market share of Indonesian exports in its 20 -20 TV recorders

Commodities for which -40 Petroleum

change in the market share of these products

12. The low level and unfavorable trend 20

relatively restrictive trade policy, but rather 16

tariffs and a composite measure of tariffs and 6

region (Figure II.5).

C. Gravity Model: Does Indonesia Undertrade Within Asia?

logtijt = α + β1 log(yit y jt ) + β2 log(GDP/ Pop)it + β3 (GDP/ Pop) jt + δi log(Distij ) + δ 2Comlangij + δ 3Colonyij +

logimijt = α + β1 log(yit y jt ) + β2 log(GDP/ Pop)it + β3 (GDP/ Pop) jt + δi log(Distij ) + δ 2Comlangij + δ 3Colonyij +

Table II.2. Panel Estimation of the Gravity Model.

Method of estimation Pooled OLS Random Effects RE Tobit Random Effects

Table II.3. Indonesia: Actual Versus Predicted Trade

Table II.3 presents the comparison of actual Deviation

trade and predicted trade patterns for Actual

or around 40 percent below potential Australia 4.2 3.1 1.1

Indonesia undertrades with the US, EU, and rest India

increased in Indonesia (Figure II.6). This is due -110

D. Impediments to Increased Integration

investment in Indonesia also lags, and has 4

sectors such as mining, metals, chemicals and -2

administration laws, as well as other reforms

• According to the IMD, Indonesia scores worse on business and government

Government efficiency Enforcing contracts Registering property

E. Has Finance Followed Trade?: Trends in Regional Financial Integration

Ishido, and Ito, 2003; Lane and Milesi- Argentina

Ferretti, 2000, Rose and Spiegel, 2002). Brunei